Skip to content

CA Final · Advanced Financial Management · Interest Rate Risk Management

A bank quotes simple-interest zero rates of 6.00% p.a. for 6 months and 7.00% p.a. for 12 months. Ignoring bid-offer spreads, what fair FRA rate (p.a.) should apply to a 6x12 FRA?

The fair 6x12 FRA rate is about 7.77% p.a. It is the rate that makes investing for six months at 6% and then for six months at the forward rate equal to investing for twelve months at 7%: 1.07 ÷ 1.03 = 1.0388, so 0.0388 × 2 gives 7.77%.

  1. A7.77%Correct
  2. B8.00%
  3. C7.00%
  4. D6.50%

Explanation

No-arbitrage requires (1 + 0.06 × 0.5) × (1 + f × 0.5) = 1 + 0.07 × 1. So 1 + 0.5f = 1.07 ÷ 1.03 = 1.038835, which gives f = 0.07767, or about 7.77% p.a. The figure 8.00% comes from the wrong shortcut 2 × 7% − 6%, which ignores compounding of the first six months.

Did you get it right without looking?

One question tells you little. A timed set on Interest Rate Risk Management shows your real accuracy, how long you take and where you lose marks.

Practise Interest Rate Risk ManagementFree diagnostic mock

More Interest Rate Risk Management questions