31 Aug Finance
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- Risk of Interest Rate Growth. Please see questions below.
- Questions
- Your company knows that it will need to borrow 20,000,000 $ in nine months’ time for a 12-months period. The interest rate at which it can borrow today is LIBOR plus 25bp. The LIBOR is currently at 0.50%, but you want to cover against the possible rise of the LIBOR in the next 9 months.
- – What financial instruments are the most suitable ones to hedge against that possible rise of interests? Provide an example and prove how it works as a risk coverage.
- You decide to take an FRA to hedge against a possible rise of interests, then, to acquire a 9×21 FRA in order to cover the period of 12 months starting 9 months from now. You receive a quote of 0.85% from the bank, and you decide to buy the FRA for a notional principal of 20,000,000$.
- On the settlement date (nine months from today), the LIBOR fixes at 0.8%. – What is the interest rate that will be applied to that loan?
- As anticipated by you, it seems that the LIBOR rose during those 9-months waiting period. – Did the Libor rise enough to get some benefit from that FRA? Or not enough?
- In case that the Libor rose in such a way that the interest rate applied to that loan is higher than the FRA, then your company will receive the settlement amount from the FRA seller.
- – Find the settlement amount. Based on the above case,
- – what will be the interests paid by that corporation for that loan?
- (only for the loan, not for the loan ± the settlement corresponding to the FRA)
- – And how much will have that Company paid in total (because of the loan plus/minus the cost/gain of the FRA)? Based on the previous information,
- – what if on the settlement date (nine months from today), the LIBOR fixes at the same level as it is now 0.50%? what would be the value of the settlement amount the company would receive from the FRA seller, if any?
- If the above mentioned company finds that FRA proposal not interesting, they may ask for a CAP contract. If the bank offers a Cap of a 1.5% at an extra cost of +10bp
- – draw the graphs (Libor in the X-axis and interest rate in the Y-axis) corresponding to the evolution of the interest rate in function of the Libor in the two cases (with and without the Cap contract)
