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

Brand Ltd will borrow $10 million for 6 months starting in 4 months. A 4v10 FRA is quoted at 5.20% (borrower). At settlement, the reference rate is 6.00%. Ignoring discounting, what is the approximate FRA settlement and the effective borrowing cost with the hedge?

Brand receives about $40,000 because the market rate is 0.80 percentage points above the FRA rate on $10 million for half a year. This offsets the higher interest, so the effective borrowing cost is the FRA rate of 5.20%.

  1. ABrand pays $40,000 to the bank; effective rate 6.00%
  2. BBrand receives $40,000 from the bank; effective rate 5.20%Correct
  3. CBrand receives $80,000 from the bank; effective rate 5.20%
  4. DBrand receives $40,000 from the bank; effective rate 6.00%

Explanation

Rate difference is 0.80%, times $10m times 6/12 equals $40,000, received by the borrower as the market rate exceeds the FRA rate. Paying 6.00% on the loan less the $40,000 receipt gives an effective 5.20%. Option three forgets the 6/12 time fraction.

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