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

Borrower Alba needs to borrow $10 million in 4 months for 6 months. A 4v10 FRA is quoted at 5.20%-5.00% (bank charges 5.20% to a borrower). At settlement, the market reference rate is 6.40%. Ignoring discounting, what is the net effective interest cost in annual terms and the FRA result?

The effective cost is 5.20%, with an FRA receipt of $60,000. The market rate is 1.20% above the fixed rate, so the bank pays 1.20% on $10 million for half a year, which offsets the higher loan interest and leaves the borrower at 5.20%.

  1. AEffective 5.20%; FRA receipt of $60,000Correct
  2. BEffective 6.40%; FRA receipt of $60,000
  3. CEffective 5.20%; FRA payment of $60,000
  4. DEffective 5.00%; FRA receipt of $70,000

Explanation

The borrower fixes at 5.20%. The market rate is 6.40%, so the bank pays 1.20% x $10m x 6/12 = $60,000. The loan costs 6.40%, less the 1.20% FRA receipt, net 5.20%. Option B ignores the offset, and C has the sign of settlement wrong.

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