Question

Below is a situation involving a FRA transaction. Please respond to the situation by commenting on the analyst’s actions. Was the analyst correct to go long? Would it have been better if he went short or just stayed out of the market.

Calculations are not necessary but are strongly encouraged. Use calculations and formulas to illuminate and validate your point of view.

You are an analyst at Everbrite Corp. serving as Asst to the Treasurer. You are based in Deligqanistan, in the Republic of Kirksytaniland. Your boss is on vacation when news of political instability in the Middle East causes interest rates to jump higher. Checking LIBOR, 90 day rates are seen as high as 3.85. This is remarkable, as only yesterday 90 day rates were 1.73%.

You wonder if there are ways to take advantage of this jump in rates. You remember that a large customer will be making a payment in the next month or two of $35 mill US. Your boss always invests the money so that at the end of the year, remittance is made to your parent back in the states as one end of year payment.

You check your banking sources and find you can lock in a rate using a FRA. Currently, an FRA can be bought with a Forward rate of 2.25. This rate is less than you thought it would be, but is up 0.40 from yesterday.

Current rates reflect the upheaval of the markets, but haven’t moved as high as you thought. You want to lock in the rate, so you call your banker. He doesn’t have much time given the volatility in the markets. He asks “What do you want?”. You mention the FRA and he says he can offer you a 3 X 9. And asks if you want it. You ask the rate again, and in a huff he says 2.25 or something like that. You say fine, I’ll take it. He says “o.k, you are long”, and hangs up.

You put the phone down and think “What did I just do?”.

Spot rates are dropping and are currently 1.97. The FRA is 2.25 for 6 months. You get an invoice for 2.13.

What did you do? Should you start thinking about the promotion you are bound to get or make sure your resume is updated?

Answer 1

Libor for 90 days / 3 months = 3.85%

FRA rate for 3 x 9 ( Loan for 6 months starting after 3 months from now ) = 2.13 %

FRA for 6 months = 2.25%

As market is upheaval , we have actually locked the FRA for a very good rate ( Better than current FRA for 6 months which is 2.25% ) and thus as a buyer of the FRA we will be getting profit. The spot rates are decreasing as a reasult of the more and more buyers for the FRA. As we know that we will be getting $ 35 mn payment in coming months :

Profit = 35,000,000 * ( 3.85% - 2.13 % ) = 35,000,000 * 0.0172 = 602,000

So, we are right to go long on the FRA assuming the rates will furthur increase.