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CA Final · Advanced Financial Management · Interest Rate Risk Management

Sundaram Textiles Ltd expects to take a floating-rate loan linked to MIBOR in three months and fears that interest rates will rise by then. It wants to lock in today's rate using a Forward Rate Agreement. Which position should it take, and when will it receive a settlement?

The company should buy the FRA, paying the fixed rate and receiving the floating rate. If the reference rate at settlement is above the FRA rate, the seller pays the company, and that payment offsets the higher interest cost on its borrowing.

  1. ABuy the FRA (pay fixed); it receives a settlement if the reference rate at settlement is above the FRA rateCorrect
  2. BSell the FRA (receive fixed); it receives a settlement if the reference rate at settlement is above the FRA rate
  3. CBuy the FRA (pay fixed); it receives a settlement if the reference rate at settlement is below the FRA rate
  4. DSell the FRA (receive fixed); it pays a settlement if the reference rate at settlement is below the FRA rate

Explanation

A borrower worried about rising rates buys the FRA, which means it pays the fixed FRA rate and receives the floating reference rate. If the reference rate at settlement exceeds the FRA rate, the seller compensates the buyer, and this offsets the higher loan interest. Selling the FRA would suit an investor fearing falling rates, so the other options reverse the roles.

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