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Hedging Interest Rate Risk Using Forward Rate Agreement

Hedging Interest Rate Risk Using Forward Rate Agreement (FRA)

These arrangements effectively allow a business to borrow or deposit funds as though it had agreed a rate which will apply for a period of time. The period could, for example start in three months’ time and last for nine months after that. Such an FRA would be termed a 3 – 12 agreement because is starts in three months and ends after 12 months.

Example:
Nero Co’s cash flow forecast shows that it will have to borrow $2m from Goodfellow’s Bank in four months’ time for a period of three months. The company fears that by the time the loan is taken out, interest rates will have risen. The current interest rate is 5% and this is offered by Helpy Bank on the required FRA.

Required
(i) What kind of FRA is needed?
(ii) What are the cash flows if the interest rate has risen to 6.5% when the loan is taken out?
(iii) What are the cash flows if the interest rate has fallen to 4% when the loan is taken out?

Solution 

(i) The FRA needed would be a 4 – 7 FRA at 5%
(ii) If the interest rate has risen to 6.5%:

$
Interest on loan paid by Nero Co to Goodfellow’s bank =
$2m x 6.5/100 x 3/12 =
 

(32,500)

Paid to Nero Co under FRA by Helpy Bank =
$2m x (6.5 – 5)/100 x 3/12 =

7,500
Net cost of the loan to Nero Co (25,000)
(iii) If the interest rate has fallen to 4%: 
$
Interest on loan paid by Nero Co to Goodfellow’s bank =
$2m x 4/100 x 3/12 =
 

(20,000)

Paid by Nero Co under FRA to Helpy Bank=
$2m x (4 – 5)/100 x 3/12 =

5,000
Net cost of the loan to Nero Co (25,000)
Note: 

(a) In both cases the effective rate of interest to Nero Co on the loan is 5%, the FRA-agreed rate: $2m x 5/100 x 3/12 = $25,000.
(b) In part (iii) when interest rates have fallen, Nero Co would no doubt wish that it had not entered the FRA so that it would not have to pay Helpy Bank $5,000. However, the purpose of the FRA is to provide certainty, not to guarantee the lowest possible cost of borrowing to Nero Co and so $5,000 will have to be paid to Helpy Bank.

Source: Ken Garrett, ACCA

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