Question #34 - Reading 30 Pricing and Valuation of Forward Commitments

Reading: Reading 30 Pricing and Valuation of Forward Commitments

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Page: 15

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Shared Context

- Which of the following comments relating to Brodeur's use of a forward rate agreement is least accurate? 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.

Question

Using the data in Exhibit 1, which of the following is closest to the forward price of the FRA?

Answer Choices:

A. 2.4%

B. 2.8%

C. 3.0%

Explanation

Step 1: Identify the correct MRR rates. We will require the MRR rate until FRA expiry (day 60) and also the MRR rate at the end of the borrowing/lending period (day 150). The 90-day MRR rate is a distractor. Elodie will borrow for 90 days but not from current date (T0). Elodie requires a 90-day loan commencing in 60 days' time. Step 2: Unannualize the quoted rates. MRR60 day = 2% × = 0.3333% MRR150 day = 2.6% × = 1.0833% Step 3: Compute the annualized forward price (fixed rate) starting in 60 days and lasting for 90 days. Forward rate = ((1 + long rate) / (1 + short rate) – 1)(360 / 90) = 2.99% (Module 30.4, LOS 30.c) 60 360 150 360 Typesetting math: 100%

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