Question #5 - Reading 30 Pricing and Valuation of Forward Commitments

Reading: Reading 30 Pricing and Valuation of Forward Commitments

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Shared Context

- Which forward rate agreement would most effectively hedge Vetements Verdun's exposure to LIBOR? A) 3 x 2. B) 2 x 5. C) 2 x 3.

Question

What must the 90-day LIBOR rate have been at the expiration of the contract?

Answer Choices:

A. 3.6%

B. 4.0%

C. 3.4%

Explanation

Since Vetements Verdun is long the FRA, the market rate of interest at settlement must be higher than the price of the contract and the 23,750 has a positive value. The interest savings at the end of the loan term will be: Interest savings = ( (market rate × (90/360)) − (0.0362 × (90/360)) ) × 25,000,000 23,750 = ((market rate × 90/360) − 0.00905) × 25,000,000 0.000950 = market rate × 90/360 − 0.00905 0.0100 = market rate × 0.25 0.0400 = market rate The market rate must have been 4.0%.

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