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

Zeta Co plans to borrow $10 million in 3 months' time for a period of 6 months and wishes to fix its interest cost using a forward rate agreement. Which FRA should it buy, and in what position will it be?

Zeta should buy a 3v9 FRA. The loan starts in 3 months and runs 6 months, so it ends 9 months from today. Borrowers buy FRAs to protect against rising rates, whereas sellers are depositors protecting against falling rates.

  1. ABuy a 3v9 FRA, which fixes the rate for a borrowing starting in 3 months and ending in 9 monthsCorrect
  2. BBuy a 6v9 FRA, which fixes the rate for a borrowing starting in 6 months and ending in 9 months
  3. CSell a 3v9 FRA, which fixes the rate for a deposit starting in 3 months and ending in 9 months
  4. DBuy a 3v6 FRA, which fixes the rate for a borrowing starting in 3 months and ending in 6 months

Explanation

An FRA is quoted as start v end, measured from today. Borrowing begins in 3 months and lasts 6 months, so it ends in 9 months: a 3v9 FRA. A borrower protects against rising rates by buying the FRA. The 6v9 and 3v6 FRAs have the wrong periods, and selling suits a depositor.

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