Tuesday, January 11, 2011

typical FRA scenario, inspired by CFA Reading 71

Today Jan 1 end user (say a top-rated borrower like IBM) anticipates it needs to borrow $xxxx in 3 months (on 1 Apr), for a term of 6 months. A dealer bank (say GS) quotes 550 bps/year. IBM agrees.

Q: what is the quotation about?
A: GS offers to lend IBM $xxxx for a 6-month term from 1 Apr to 30 Sep [1]. Rate is 550 bps, regardless of the fluctuating 6-month Libor rate.

[1] more likely to be a fixed 180 days. I feel this way Libor rate is more comparable.

Q3: Locking -- IBM effectively locks its borrowing cost at 550. Why?
A3: IBM will inevitably borrow from open market comes 1 Apr. If that becomes 600 bps, IBM pays 600 but _receives_ the difference. If that becomes 500, IBM pays 500 but _pays_ the difference to GS.

Q3b: why inevitable? Why not from the FRA dealer.
%%A: I guess GS may not have enough fund to lend; IBM may borrow from multiple banks; IBM may cancel its project. IBM just wants to lock down the borrowing cost in case it needs to borrow on 1 Apr.
%%A: the contract doesn't require both parties to close the 3-month loan. The contract stipulates cash settlement as in A3 above. Therefore IBM doesn't have to take the loan or take it from GS.

If Libor becomes 600 bps on 1 Apr, then IBM is lucky to lock its borrowing cost at 550 bps. It receives a sum from GS equal to the difference.

Q5: Why lucky? What if no FRA?
A: IBM would end up paying 600.

Q5b: what if it turns to be 500 bps?
A: IBM will end up paying 500 but as a borrower IBM needs predictable borrowing cost, so it can plan long term.

Therefore IBM wants Libor to rise i.e. it is long Libor, but IBM doesn't get unlimited profit as it probably still needs to borrow at the high Libor rate.

Q8: in a commodity (similarly stock / bond / FX) forward contract, there's a physical item to be delivered at expiration. What's it in FRA?
A: At expiration on 1 Apr, IBM receives the right to the 6-month deposit interest at prevailing Libor rate. At the same time it must pay the 550 bps to GS. Net payment is not on 1 Jan, not 30 Sep, but on 1 Apr.

Q8b: how is this similar to a commodity forward?
A: At expiry, IBM receives the commodity, and pays a pre-agreed contract price, not the prevailing price. In FRA, the physical deliverable is ... a piece of paper for the interest on a CD, 6-month CD at the prevailing Libor rate at, say, 600 bps / year

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