5 i 3 8
[1+0.098 X --- ] [1 + ---- X --------] = [1 + 0.105 X --- ]
12 100 12 12
or
I = 11.2 percent
Thus, the treasury manager has been able to lock in an effective rate of 11.2 percent. The
interest on his borrowings would amount to:
Illustration
Problem 15
A company will need to buy after 4 months a forward rate agreement (FRA) from a bank
to borrow for 3 months. The 4/7 FRA is quoted at 6.5. What will the company do if after
4 months, the rate?
(a) rises to 7 percent
(b) falls to 6 percent
(c) remains at 6.5 percentSolution 15
(a) Since the rate has risen, the counter-party (the bank in this case) will pay the
difference to the company. Say, the borrowings are planned for $ 1 million.
Then the counter-party is to pay to the company:
3
(0.07 – 0.06) X 1,000,000 X ---
12
= $ 2500(b) Since the rate has fallen to 6 percent, the company will pay to the bank, an
amount:
3
(0.065 – 0.06) X 1,000,000 X ---
12
$ 1250.© Since there has been no change in the rate, neither the bank nor the
Company pays or receives.(Source: Book on International Financial Management by professors P.K.Jain, Josette
Peyrard and Surendra S Yadav)