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IAI Actuarial Core Principles · Business Finance · Financial instruments issued or used by companies

An Indian company expects to borrow Rs 100 crore in six months for a six-month period and buys a forward rate agreement (FRA) fixing 7.0% a year. At settlement, the reference rate is 8.0% a year. Ignoring discounting, which statement is correct?

The company receives about Rs 0.5 crore. As a borrower it fixed 7% and the market rate is 8%, so the counterparty pays the 1% difference on Rs 100 crore for six months. The Rs 1.0 crore figure wrongly uses a full year.

  1. AThe company receives a payment of about Rs 0.5 crore from the FRA counterparty, offsetting its higher borrowing costCorrect
  2. BThe company pays about Rs 0.5 crore to the FRA counterparty
  3. CThe company receives about Rs 1.0 crore as the full annual rate difference
  4. DThe company receives nothing, because the FRA lapses if rates rise
  5. The company pays about Rs 1.0 crore because rates rose

Explanation

The borrower fixes the rate at 7% and the market rate is 8%, so the borrower receives the difference. The difference is 1% a year on Rs 100 crore for half a year, which is Rs 0.5 crore. Using the full year gives Rs 1.0 crore, which overstates it by ignoring the six-month period.

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