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CA Final · Advanced Financial Management · Interest Rate Risk Management

Meridian Textiles Ltd expects to borrow Rs 10 crore for 6 months starting 3 months from today and wants to lock in its borrowing cost using an FRA. Which FRA should it buy, and what does buying the FRA mean for the company?

The company should buy a 3x9 FRA because the loan begins in three months and ends in nine months. A buyer of an FRA gains when the reference rate at settlement exceeds the agreed rate, which offsets higher borrowing cost.

  1. ABuy a 3x9 FRA; it receives the settlement if the reference rate at settlement is above the agreed FRA rateCorrect
  2. BBuy a 3x6 FRA; it pays the settlement if the reference rate at settlement is above the agreed FRA rate
  3. CSell a 3x9 FRA; it receives the settlement if the reference rate at settlement is above the agreed FRA rate
  4. DBuy a 6x9 FRA; it receives the settlement if the reference rate at settlement is below the agreed FRA rate

Explanation

The loan starts in 3 months and ends in 9 months, so a 3x9 FRA fits. A borrower hedges by buying the FRA, which pays the buyer when the reference rate exceeds the agreed rate, offsetting the higher borrowing cost. The 3x6 option has the wrong period, and a buyer does not pay when rates rise.

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