Page 222 - AFM Integrated Workbook STUDENT S18-J19

Chapter 11

Illustration 1

Island Co is planning to borrow $3 million in 3 months’ time to fund the first
phase of a new investment project. It is expected that the borrowing will be
repaid six months’ later.

The finance director is concerned that interest rates might rise, so he is keen to
use a forward rate agreement (FRA) to lock the company into a fixed interest
rate.

The following FRA rates have been provided by Island Co’s bank:

3 – 6 4.50% – 4.67%

3 – 9 4.60% – 4.80%

6 – 9 4.75% – 4.96%

Required:

Calculate the company’s overall financing cost if the interest rate in three
months’ time is (a) 3% or (b) 5%.

Solution

$ 3% 5%

Interest 3% × $3 million × 6/12 (45,000)

5% × $3 million × 6/12 (75,000)

FRA (4.80% – 3%) × $3 million × 6/12 (27,000)

(4.80% – 5%) × $3 million × 6/12 3,000

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Net (effective rate 4.80%) (72,000) (72,000)

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