CA FINAL SFM

FORWARD RATE AGREEMENTS (FRAS)

PRACTICAL QUESTIONS
1. M/s. Parker & Co. is contemplating to borrow an amount of Rs.60 crores for a period of 3
months in the coming 6 months time from now. The current rate of interest is 9% p.a.,
but it may go up in 6 months time. The company wants to hedge itself against the likely
increase in interest rate.
The Companys Bankers quoted an FRA (Forward Rate Agreement) at 9.30% p.a.
What will be the effect of FRA and actual rate of interest cost to the company, if the
actual rate of interest after 6 months happens to be (a) 9.60% p.a. and (b) 8.80% p.a.?
Ans.: (a) If actual interest rate is 9.6% p.a. on the effective date then, M/s Parker & Co. will
receive the following amount from its bankers
= 60 crores x (9.6 9.3%) x 3/12 x 100/102.4
= Rs.4,39,453
(b) If actual interest rate is 8.8% p.a. on the effective date, then M/s Parker & Co. will pay
the following amounts
= 60 crores x (9.3 8.8%) x 3/12 x 100/102.2
= Rs.7.33,855
2. TM Fincorp has bought a 6 x 9 Rs.100 croresForward Rate Agreement (FRA) at 5.25%.
On fixing date reference rate i.e. MIBOR turns out be as follows:
Period

Rate (%)

3 months

5.50

6 months

5.70

9 months

5.85

You are required to determine:

a) Profit/Loss to TM Fincorp. in terms of basis points.
b) The settlement amount.
(Assume 360 days in a year)
Ans.: a) Calculation of profit/loss to TM Fin corp. in terms of basis points
TM Fincorp has bought a 6 x 9 FRA which means that it is a borrower and the
underlying reference rate is 3M MIBOR
Strike rate = 5.25%

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CA FINAL SFM
Ref rate on effective date = 5.50%
Therefore, TM Fincrop will make a profit of 0.25%
b) Calculation of settlement amount
100 crores x 0.25% x 3/12 x 100/101.375
= 6,16,522.81
As per ICAI solution,
100 crores x (5.5% - 5.25%) x 92/360 x 100/101.4056
= Rs.6,30,033
Note: If they are silent on the day count always support your answer with an
assumption
3. The following market data is available. We are given that 30 days rate is 11% and the 120
days rate is 10.32%. A 1 x 4 FRA is planned to be bought. What should be the FRA rate
for no - arbitrage situation?
Ans.: It is calculated using the expectation theory of interest rates on annual compounding
basis
(1 + ROI for 120 days) = (1 + ROI for 30 days) (1 + ER for the period 31 120 days)
1.0339 = (1 + 0.0090) (1 + ER)
1.0339/1.0090 = 1 + ER
Therefore, ER = 0.024678
Therefore, ER = 2.4678 x 365/90 = 10.008%
If computed on CCRI basis,

ER =

(R2 x T2) (R1 x T1)

(T2 T1 )

= (0.1032 x 120) (0.11 x 30)

365

365

120 30
365

= 0.0339 0.0090

365

x 365

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90
So, ER = 10.098%
4. The following market data is available:
Spot USD/JPY 116.00
Deposit rates p.a.

USD

JPY

3 months

4.50%

0.25%

6 months

5.00%

0.25%

Forward Rate Agreement (FRA) for Yen is Nil.

What should be 3 months FRA rate at 3 months forward?
Ans.: It is given that FRA for a Yen is Nil. This is because its ROI for 3M and 6M is 0.25%
We can find out 3 x 6 FRA rate for US $ using the expectation theory on interest rates as
shown hereunder
(1 + ROI for 6M) = (1 + ROI for 3M) (1 + Expected (3 x 6) Rate)
(1 + 0.025) = (1 + 0.01125) (1 + ER)
__1.025

1 = ER

1.01125
Therefore, ER = 0.0136 = 1.36% for 3 months
Therefore, Annualized 3M FRA Rate = 1.36 x 12 = 5.4% p.a
5. The 6 & 12 months LIBORS are 5% & 6.5% respectively. A bank is quoting 6/12 USD FRA
at 6.50 6.75%. Is any arbitrage opportunity available? Calculate profit in such case.
Ans.: 6 Months interest rate 5%
12 Months interest rate 6.5%
6 x 12 FRA rate 6.5 6.75%
We should first find out what should be the expected ROI for 1st 6 month for a further
period of 6 month
(1 + ROI for 12 month) = (1 + ROI for 6 months) (1 + ER [6 x 12])
(1 + 0.065) = (1 + 0.025) (1 + ER)
1.065 = (1 + 025) (1 + ER)
Therefore, 1.065 = (1.025) (1 + ER)

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Therefore, 1 + ER = 1.065
1.025
Therefore, ER = 0.039
Therefore, for 6 months = 0.039
Therefore, for 12 months = 0.039 x 2 = 7.8%
Ideally the 6 x 12 rate of interest should have been 7.8%. However, the bank has quoted
FRA at 6.5 6.75% p.a. Therefore, there is a scope of making arbitrage profit. FRA is
cheaper and the same should be purchased. In other words amount will be borrowed
from the bank covering the interest rate under FRA @ 6.75% p.a.
Arbitrage Transaction:
1. Borrow money for 6 months @ 5%
2. Invest the same for 12 months @ 6.5% p.a.
3. To liquidate the borrowing at the end of 6 months borrow money from the bank
under FRA @ 6.75% p.a.
Lets consider a national amount of $ 1,00,000 under FRA
1. Borrow PV of Rs. 1,00,000 at 5% p.a. ROI = 1,00,000x 100_ = $ 97,561
102.5
2. Borrow $ 1,00,000 at 6.75% FRA rate after 6 months for further 6 months
Therefore, Maturity proceeds = 1,00,000 + (1,00,000 x 6.75% x 6/12) = 1,03,375 $
3. Invest $ 97,561 for 12 Months @ 6.5% p.a. The maturity proceeds = 97,561 + 97,561 x
6.5% = $ 1,03,902
Therefore, Arbitrage Profit = 1,03,902 1,03,375
= 527 $

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