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CA Final · Advanced Financial Management · Interest Rate Risk Management

Kaveri Auto Components Ltd buys a 6 x 12 FRA from a bank on a notional principal of Rs 10 crore at an FRA rate of 7.00% p.a. At the start of the FRA period (month 6) the reference rate is fixed at 8.00% p.a. Assume a 180-day period on a 360-day basis, with settlement made at the start of the period by discounting at the reference rate. What is the settlement?

Kaveri receives about Rs 4,80,769. The buyer gains because the reference rate of 8% is above the FRA rate of 7%. The interest difference is Rs 5,00,000 for half a year, and since it is settled upfront it is discounted at 8% for the period.

  1. AKaveri receives Rs 4,80,769Correct
  2. BKaveri receives Rs 5,00,000
  3. CKaveri pays Rs 4,80,769
  4. DKaveri receives Rs 4,83,092

Explanation

The buyer gains because the reference rate (8%) exceeds the FRA rate (7%). Interest differential = 10,00,00,000 x 1% x 180/360 = Rs 5,00,000. Discounting at the reference rate: 5,00,000 / (1 + 0.08 x 0.5) = 5,00,000/1.04 = Rs 4,80,769. Using Rs 5,00,000 ignores discounting. Dividing by 1.035 wrongly discounts at the FRA rate.

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