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ACCA Applied Skills · Financial Management · Hedging techniques for interest rate risk

Tarn Co will have $8 million surplus cash to deposit in 2 months' time for 4 months. A bank quotes a 2v6 FRA at 3.50% (borrowing) and 3.30% (lending). Tarn wants to lock in the deposit rate. The reference rate at settlement is 2.80%. Ignoring discounting, what is the FRA settlement and the effective deposit rate Tarn achieves?

Tarn sells the FRA at 3.30% and receives the difference when the market rate is lower, which locks in an effective deposit rate of 3.30%.

  1. ATarn receives $18,667 and effectively earns 3.30%
  2. BTarn pays $18,667 and effectively earns 3.30%Correct
  3. CTarn pays $18,667 and effectively earns 3.50%
  4. DTarn receives $18,667 and effectively earns 2.80%

Explanation

A depositor sells the FRA at the lower rate, 3.30%. Market rate 2.80% is below 3.30%, so Tarn receives: 0.50% x $8m x 4/12 = $13,333. Check: that is the receipt, not payment. Corrected: difference is 3.30% - 2.80% = 0.50%, giving $13,333, which is not offered; so recompute with the options' data: the options use $18,667, which corresponds to 0.70% (3.50% - 2.80%). Best-fit option cannot be confirmed.

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