Question #33

Reading: Reading 30 Pricing and Valuation of Forward Commitments

PDF File: Reading 30 Pricing and Valuation of Forward Commitments.pdf

Page: 15

Status: Unattempted

Part of Context Group: Q33-36 First in Group
Shared Context
of 77 The value of a futures contract between the times when the account is marked-to-market is: A) never less than the value of a forward contract entered into on the same date. B) equal to the difference between the price of a newly issued contract and the settle price at the most recent mark-to-market period. C) the same as the contract price. Elodie Brodeur works in the finance department of a large fashion house in France. The international catwalk season will start in two months' time and Brodeur has worked out that the company will need a 3-month loan of €4m in two months' time. The company's lenders are typically retail banks offering loans at MRR plus 40 basis points. Brodeur is concerned that interest rates may rise during the next two months and wants to use a FRA to lock-in the borrowing cost. Brodeur has collected the rate information shown in Exhibit 1. Exhibit 1: Current MRR Rates 60 day MRR 2.0% 90 day MRR 2.4% 150 day MRR 2.6% 210 day MRR 2.9% One month after the initiation of the FRA the MRR rates are shown in Exhibit 2. Exhibit 2: MRR Rates One Month Later 30 day MRR 1.8% 90 day MRR 2.5% 120 day MRR 2.8% 180 day MRR 3.0% At the expiration of the FRA, 90-day MRR is 3.4%.
Question
Which of the following comments relating to Brodeur's use of a forward rate agreement is least accurate?
Answer Choices:
A. A short FRA can be used to lock into a fixed rate of borrowing commencing in two months’ time and expiring in five months’ time
B. The use of a FRA to hedge interest rate risk would lock Brodeur into paying a fixed rate plus 40 basis points for her borrowing
C. The use of a FRA to hedge interest rate risk on her future loan will mean that she no longer benefits if interest rates fall
Explanation
Typesetting math: 100% A long FRA will create the obligation to pay fixed and receive floating from months 2 to month 5. The floating payments will offset her bank loan leaving her with a pay fixed obligation, where the fixed rate is determined today. The floating receipt on the FRA and the floating payment on the loan she will need to take out will offset leaving a net payment of 40 basis points. Overall, she will now pay the fixed rate on the swap plus the 40 basis points on the loan. The use of a long FRA will lock Elodie into paying fixed interest rate on the FRA (the FRAs forward price) plus the basis points on her loan above MRR. Elodie will no longer benefit from interest rate declines but will be protected from interest rises.
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