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Interest Rate Risk Hedging- Determing the FRA & the whole question concept.

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Interest Rate Risk Hedging- Determing the FRA & the whole question concept.

The question stated that now is mid-December, the company HAS borrowed $30 million from the capital market to purchase equipment. The $30 million is due in 2 month’s time.

Thus, I understand that settlement date is on mid- February, where the company has to start borrowing the loan.

NO information was given as to how long the period for the loan to be fully repaid.

However, The answer given was:
1. To assume the loan was borrowed in Mid Dec, and repaid on February.
*I don’t understand this. Shouldn’t the loan be borrowed BEGINNING on Mid-February? as Payment was only Due on Mid-February itself.

  1. Then came a second ans, saying that we should just assume the loan is borrowed in 2 months time, and repaid in 2 months.
    *Is it possible to just assume that the hedging period length (mid dec to mid feb i. e. 2 months) , is equivalent to the company's borrowing period?
  • Also, I would like to know if it is possible to hedge AFTER borrowing?
  1. FRA prices were given for 3v6, 3v5, 3v8. The answer was, as the question implies that the loan was borrowed for 2 months ( mid dec to mid feb), we should just take the nearest accurate FRA price, which is 3v5.

*From what I understand, FRA 3v5 means to borrow a loan in 3 months time for a period of 5 months. So, is it really acceptable to assume that FRA 3v5 can be used on a 2 month loan?

This is a university exam question (internal), and I do not understand the answers. Hopefully someone could explain it! (Do feel free to voice out your views if you feel that the question is incomplete or the answer provided is inaccurate or unacceptable.)

May 11th 2017 AN ACCA USER 120 Points

1 Reply

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Based on your question:

  1. borrow in mid-Dec and due means settle loan by 2 months times (means mid-feb).
  2. we hedge the period until we borrow that time(means mid-Feb).
  3. FRA 3v5 is actually explain that repaid in 2months time.(is should be borrow money in 3months time later in a period of 5months )

Not sure is it correct but hope its help.

May 16th 2017 AN ACCA USER 240 Points