– 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)
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