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ACCA Strategic Professional · Advanced Financial Management · The use of financial derivatives to hedge against interest rate risk

A company holds a 6v12 FRA bought at 3.80%. At settlement the reference rate is 3.20%. Which statement about the outcome is correct?

The company pays the bank the 0.60% difference. Because the buyer of an FRA pays when the market rate falls below the agreed rate, its cheaper actual borrowing at 3.20% is offset, leaving an effective cost of 3.80%.

  1. AThe company receives the rate difference from the bank because rates have fallen
  2. BThe company pays the bank the rate difference, so its effective borrowing cost remains 3.80% when combined with the underlying loan at 3.20%Correct
  3. CThe company pays the bank nothing because FRAs cannot produce payments by the buyer
  4. DThe company receives the bank's payment and benefits from the lower rate in addition

Explanation

The buyer of an FRA pays when the reference rate is below the agreed rate. The company borrows at about 3.20% and pays the 0.60% difference to the bank, giving a net cost of 3.80%. Receipt would only occur if rates had risen. FRAs lock in the rate and remove the favourable movement.

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