Question

Citibank need to borrow $1 million for 6 months starting in 1 years.  Citibank is concerned about the interest rate would like to lock in the interest rate it pays by going long an FRA with Bank of America.  The FRA specifies that Citibank will borrow at a fixed rate of 0.02 for 6 months on $1 million in 1 years. If the 6 months LIBOR rate proves to be 0.04. Then to settle the FRA, what is the cash flow to Citibank at the end of 1 years? Please be careful with the sign (positive/negative) of your answer and keep your answer to 2 decimal points.

Answer 1

Solution-Citibank has afraid of interest rate rising in future.so citibank entered into forward rate agreement at a fixed rate 0.02 for 6 month.Now irrespective of rate of borrowing in futre citibank cost of borrowing is 0.02.

Now 6 month libor is .04.So now profit to citibank is due to cancel for FRA to current libor= (0.04-0.02)*$1000000=$20000

After settlement of FRA citibank borrow at 6m libor.so outflow after after 1 year is =$1000000*.004=$40000

Net outflow to citibank is =Interest on borrowing-profit on fra settlemant

=$40000-$20000=$20000