Question

A financial manager wants to hedge against interest rate risk and decided to invest in a FRA that expires in 90 days, based on a 90-day LIBOR rate, in order to hedge against an increase in short term interest rates. The current term structure of LIBOR sets the rate on the FRA at 6.20%. Thirty (30) days later the interest rates have shifted and the term structure changed as follows: Term : 60 days Interest rate 4.70% and Term: 150 days interest rate 4.95%

Calculate the market value of the FRA based on a notional amount of R20 million and indicate whether the manager gained or lost from this transaction.

Answer 1

Investor wants to hedge against an increase in short-term interest rates. Therefore, the investor will enter into an FRA such that the investor pays the fixed FRA rate and receives the floating LIBOR rate. The value of the FRA contract 30 days from now will equal the present value (at that time) of the difference between the floating interest cash flow received and the fixed interest cash flow paid.

Fixed FRA Rate = 6.2%, 30 days later: Floating Interest Rate = 60 day LIBOR = 4.7 % and 150 day LIBOR = 4.95 %, Contract Duration = 90 days

Notional = R 20 million

Value of FRA Contract after 30 days = [(0.047-0.062) x 20000000 x (90/360)] x [1/(1+(0.0495) x (150/360)] = - R 73484.38

As the FRA value to the investor is negative, the manager lost from this the transaction