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

Company X will borrow $20 million in 4 months for 6 months. The 4v10 FRA quote is 4.20% - 4.00%. At settlement, the reference rate is 5.00%. Ignoring discounting of the settlement amount and basis-point rounding, what is the net effective interest cost for the 6-month period, if the company bought the FRA and borrows at the reference rate?

The effective rate is 4.20%. The company buys the FRA at the bank's higher rate. It pays 5.00% on the loan but receives 0.80% from the FRA, so the net cost is fixed at the FRA rate of 4.20%.

  1. A4.20%Correct
  2. B4.00%
  3. C5.00%
  4. D5.20%

Explanation

The company buys the FRA at the higher quoted rate, 4.20%. It pays 5.00% on the loan but receives (5.00% - 4.20%) = 0.80% from the FRA, so the net rate is 4.20%. The 4.00% rate is the bank's buying rate, which applies to depositors. The 5.00% option ignores the hedge.

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