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Interest rate risk

Question 2

Forward rate agreements

Newt Co will need to borrow €55 million in 3 months’ time for 6 months.

A 3–9 FRA is available at 6.6% – 6.3% per annum

Calculate the interest payable (and show the details of the individual elements)
if the interest rate moves to (i) 7%, (ii) 6% per annum by the date of the
borrowing.

Borrowing rate is the higher of the spread so the rate will be effectively fixed at
6.6%

(i) Interest paid on underlying borrowing: €55m × 7% × 6/12 = €1,925,000

As the interest rate is higher than the FRA rate, the FRA bank must pay
the difference over to Newt Co: €55m × (7% – 6.6%) × 6/12 = €110,000.

Net interest paid = €1,925,000 – €110,000 = €1,815,000

(ii) Interest paid on underlying borrowing: €55m × 6% × 6/12 = €1,650,000

As the interest rate is lower than the FRA rate, Newt Co must pay over the
difference to the FRA bank: €55m × (6.6% – 6%) × 6/12 = €165,000

Total interest paid = €1,650,000 + €165,000 = €1,815,000.

Either way the net position is a payment at 6.6% (€55m × 6.6% × 6/12 =
€1,815,000)

Illustrations and further practice

Now try TYU questions 1 and 2 from Chapter 14

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