WN 1: Computation of FRA rate:

• The company wants 3 months FRA rate at 3 months forward. This would technically mean
3x6 FRA

Future value factor for 6 months

3x6 FRA = −1
Future value factor for 3 months

𝟏 + 𝟐. 𝟓𝟎%
𝟑𝐱𝟔 𝐅𝐑𝐀 = − 𝟏 = 𝟏. 𝟎𝟏𝟑𝟔 − 𝟏 = 𝟏. 𝟑𝟔% 𝐩𝐞𝐫 𝟑 𝐦𝐨𝐧𝐭𝐡𝐬 (𝐨𝐫)𝟓. 𝟒𝟒% 𝐩𝐞𝐫 𝐚𝐧𝐧𝐮𝐦
𝟏 + 𝟏. 𝟏𝟐𝟓%

WN 2: Computation of 6X12 FRA rate:

• We have been given 6 months and 12 months rate as 5% and 6.5%. We can use these rates and
calculate 6X12 FRA rate

Future value factor for 12 months

6x12 FRA = −1
Future value factor for 6 months

𝟏 + 𝟔. 𝟓𝟎%
𝟔𝐱𝟏𝟐 𝐅𝐑𝐀 = − 𝟏 = 𝟏. 𝟎𝟑𝟗𝟎 − 𝟏 = 𝟑. 𝟗𝟎% 𝐩𝐞𝐫 𝟔 𝐦𝐨𝐧𝐭𝐡𝐬 (𝐨𝐫)𝟕. 𝟖𝟎% 𝐩𝐞𝐫 𝐚𝐧𝐧𝐮𝐦
𝟏 + 𝟐. 𝟓𝟎%

Creation of arbitrage:
• Fair FRA rate for month 6 to 12 is 7.80% per annum. Actual FRA rate is 6.50% - 6.75%.
• Actual FRA indicates that borrowing can be made at 6.75% and deposit can be created at 6.50%
for month 6 to 12
• Actual borrowing rates are lower than Fair FRA rates and hence we should borrow money
from month 6 to 12
• Arbitrage Mechanism:
o Borrow 1,00,000 USD for first 6 months
o Create 1,00,000 USD deposit for 12 months
o Borrow from M6 to M12 using FRA rate

Arbitrage steps:
Particulars Calculation Amount
Day 0
1. Borrow 1,00,000 USD for 6 months @ 5% 1,00,000
2. Create 12-month deposit @ 6.50% 1,00,000
3. Enter into FRA to borrow money from M6 to
M12 @ 6.75%
Day 180
4. Repay 6-month loan with fresh borrowing @ 1,00,000 + (1,00,000 x 5% x 1,02,500
6.75% as per FRA 6/12)
Day 365:
5. Maturity value of 12-month deposit 1,00,000 + (1,00,000 x 6.5%) 1,06,500
6. Repay loan along with interest 1,02,500 + (1,02,500 x 6.75% x 1,05,959
6/12)
7. Arbitrage gain 1,06,500 – 1,05,959 541

Question No.11:

WN 1: Computation of FRA rate:

• The company wants to borrow after 2 years for a period of 1 year. The company therefore is
looking at getting 2x3 FRA rate
XYZ Limited:

Future value factor for 3 years (1 + 4.48%)3

2x3FRA = −1 = − 1 = 5.04%
Future value factor for 2 years (1 + 4.20%)2

ABC Limited:

Future value factor for 3 years (1 + 5.78%)3

2x3FRA = −1 = − 1 = 6.38%
Future value factor for 2 years (1 + 5.48%)2

WN 2: Computation of actual interest with interest rate guarantee:

• Interest rate guarantee is either a cap or floor option depending on whether we are borrower
or lender
• XYZ Limited is borrower and they would want to restrict the maximum interest outflow
• It is assumed that strike rate of option is equal to fair FRA rate of 5.04%

Actual interest rate is 4.50%

• XYZ Limited will pay 4.50% and their overall cost will be 4.60% including premium

Actual interest rate is 5.50%

• XYZ Limited will pay 5.04% and their overall cost will be 5.14% including premium

Question No.12
WN 1: Effect of FRA:
• The company wants to borrow after 3 months for entire slack season of 6 months. This would
mean borrowing from M3 to M9.
• The company should enter into 3x9 FRA to hedge interest rate risk
• Relevant 3x9 FRA borrowing rate is 5.94%
Particulars Actual rate of Actual rate of
4.50% 6.50%
1. Payment to original lender 4.50% 6.50%
2. Payment by Electraspace to bank (FRA settlement) 1.44% -
3. Receipt by Electraspace from Bank (FRA settlement) - (0.56%)
4. Net borrowing cost 5.94% 5.94%

WN 2: Hedging through interest rate futures:

• The company wants to borrow 50 million for 6 months. Futures contracts are available only for
3 months and hence we should adjust the value of futures contract
• Borrowing 50 million for 6 months is similar to borrowing 100 million for 3 months

Amount to be hedged 100 million

No of futures contracts = = = 2,000 Contracts
Size of one contract 50,000

Actual interest rate is 4.50%

Particulars Calculation Amount
1. Interest to be paid on original loan 50 million x 4.50% x 6/12 11,25,000
2. Futures settlement (Note 1) 3,37,500
3. Total outflow 14,62,500
4. Effective borrowing cost 𝟏𝟒, 𝟔𝟐, 𝟓𝟎𝟎 𝟏𝟐 5.85%
𝐱 ( ) 𝐱 𝟏𝟎𝟎
𝟓𝟎 𝐦𝐢𝐥𝐥𝐢𝐨𝐧 𝟔

Note 1: Computation of futures settlement:

 Date Position Action Reference Date Rate
Day 0 Original Position Borrow Day 90 5.85%
Day 90 Opposite Position Lend Day 90 4.50%
Loss in % 1.35%
𝟑 3,37,500
𝐋𝐨𝐬𝐬 𝐢𝐧 𝐫𝐮𝐩𝐞𝐞𝐬 (𝟏𝟎𝟎 𝐦𝐢𝐥𝐥𝐢𝐨𝐧 𝐱 𝟏. 𝟑𝟓% 𝐱 ( )
𝟏𝟐

Actual interest rate is 6.50%

Particulars Calculation Amount
1. Interest to be paid on original loan 50 million x 6.50% x 6/12 16,25,000
2. Futures settlement (Note 1) (1,62,500)
3. Total outflow 14,62,500
4. Effective borrowing cost 𝟏𝟒, 𝟔𝟐, 𝟓𝟎𝟎 𝟏𝟐 5.85%
𝐱 ( ) 𝐱 𝟏𝟎𝟎
𝟓𝟎 𝐦𝐢𝐥𝐥𝐢𝐨𝐧 𝟔

Note 1: Computation of futures settlement:

Date Position Action Reference Date Rate
Day 0 Original Position Borrow Day 90 5.85%
Day 90 Opposite Position Lend Day 90 6.50%
Profit in % 0.65%
𝟑 1,62,500
𝐏𝐫𝐨𝐟𝐢𝐭 𝐢𝐧 𝐫𝐮𝐩𝐞𝐞𝐬 (𝟏𝟎𝟎 𝐦𝐢𝐥𝐥𝐢𝐨𝐧 𝐱 𝟎. 𝟔𝟓% 𝐱 ( )
𝟏𝟐

Question No.14:
WN 1: Structure of interest rates:
Particulars Fixed rate Floating rate
M Limited 8% T+0.6%
S Limited 9.2% T+1.2%

• Total interest rate of combination 1 [M limited (fixed) & S Limited (Floating)] = 8% + T + 1.2%
= T+9.2%
• Total interest rate of combination 2 [M limited (floating) & S Limited (fixed)] = T + 0.6% + 9.2%
= T+9.8%
• Ideal combination = Combination 1; This would mean that M Limited should borrow at fixed
rate and S Limited should borrow at floating rate
• Actual scenario: M Limited plans to borrow at floating rate and S Limited plans to borrow at
fixed rate
• Scope for Interest rate swap exist as the ideal and actual scenario does not match
• Swap gain = Difference in total interest of combination 1 & 2 = (T + 9.8%) – (T + 9.2%) = 0.6%
• Share of swap gain (equal gain):
o M Limited = 0.30%
o S Limited = 0.30%

WN 2: IRS structuring:
Particulars M Limited S Limited
1. Pay to banker as per ideal rate 8% T + 1.2%
2. M Limited to S Limited T (T)
3. S Limited to M Limited (b/f) (7.7%) 7.7%
4. Effective borrowing rate T + 0.3% 8.9%

Notes:
 • M Limited wanted to borrow at floating rate. They will be asked to pay Treasury bill rate to S
Limited and this would swap their fixed loan to a floating loan
• Effective borrowing rate = Original rate – share of swap gain
• S Limited payment to M Limited will be taken as balancing figure

WN 3: IRS structuring if gain is shared in the ratio of 3:1

Share of swap gain:
• M Limited = 0.60 x (3/4) = 0.45%
• S Limited = 0.60 x (1/4) = 0.15%

Particulars M Limited S Limited

1. Pay to banker as per ideal rate 8% T + 1.2%
2. M Limited to S Limited T (T)
3. S Limited to M Limited (b/f) (7.85%) 7.85%
4. Effective borrowing rate T + 0.15% 9.05%

WN 4: IRS Structuring with swap intermediary:

Share of swap gain:
• Intermediary = 0.10% (assumed to be combined charge from both companies)
• M Limited = 0.25%
• S Limited = 0.25%

Structuring for M Limited:

Particulars M Limited
1. Pay to banker as per ideal rate 8%
2. M Limited to intermediary T
3. Intermediary to M Limited (bal figure) (7.65%)
4. Effective borrowing rate T + 0.35%

Structuring for S Limited:

Particulars S Limited
1. Pay to banker as per ideal rate T + 1.20%
2. S Limited to intermediary (bal figure) 7.75%
3. Intermediary to S Limited (T)
4. Effective borrowing rate 8.95%

Question No.22:
WN 1: Structure of interest rates:
Particulars Fixed rate Floating rate
IM 4% LIBOR + 0.50%
JI 4.25% LIBOR + 2.5%

• Total interest rate of combination 1 [IM limited (fixed) & JI Limited (Floating)] = 4% + LIBOR
+ 2.5% = LIBOR + 6.5%
• Total interest rate of combination 2 [IM limited (floating) & JI Limited (fixed)] = LIBOR + 0.5%
+ 4.25% = LIBOR + 4.75%
• Ideal combination = Combination 2; This would mean that IM Limited should borrow at
floating rate and JI Limited should borrow at fixed rate
• Actual scenario: IM Limited plans to borrow at floating rate and JI Limited plans to borrow at
fixed rate
• Scope for IRS does not exist as the actual scenario is in line with ideal scenario
• Effective borrowing rate for IM = LIBOR + 0.5%
• Effective borrowing rate for JI = 4.25%