LOS f: Describe the characteristics of forward rate agreements (FRAs).

Q1. The short in a forward rate agreement:

A)   profits if LIBOR decreases.

B)   faces default risk.

C)   profits if London Interbank Offered Rate (LIBOR) increases.

Q2. A forward rate agreement (FRA):

A)   can be used to hedge the interest rate exposure of a floating-rate loan.

B)   is settled by making a loan at the contract rate.

C)   is risk-free when based on the Treasury bill rate.

Q3. An FRA is:

A)   the Futures Regulatory Administration.

B)   a Forward Riskfree Asset.

C)   a Forward Rate Agreement.

Q4. A forward rate agreement (FRA):

A)   can sometimes be viewed as the right to borrow money at below-market rates.

B)   requires the long to pay cash to the short if the rate specified in the contract at expiration is below the current floating rate.

C)   generally uses a fixed reference interest rate.

fficeffice" /> 

LOS f: Describe the characteristics of forward rate agreements (FRAs).

Q1. The short in a forward rate agreement:

A)   profits if LIBOR decreases.

B)   faces default risk.

C)   profits if London Interbank Offered Rate (LIBOR) increases.

Correct answer is B)

Each party to a forward contract faces default risk to some extent. If the floating rate at contract expiration (LIBOR or Euribor) is above the rate specified in the forward rate agreement (FRA), the long position in the contract can be viewed as the right to borrow at below market rates and the long will receive a payment from the short. If floating rates (LIBOR or Euribor) at the expiration date are below the rate specified in the FRA the short will receive a cash payment from the long. However, "the short profits if LIBOR decreases" is not necessarily true because LIBOR can decrease but remain above the rate specified in the FRA.

Q2. A forward rate agreement (FRA):

A)   can be used to hedge the interest rate exposure of a floating-rate loan.

B)   is settled by making a loan at the contract rate.

C)   is risk-free when based on the Treasury bill rate.

Correct answer is A)        

An FRA settles in cash and carries both default risk and interest rate risk, even when based on an essentially risk-free rate. It can be used to hedge the risk/uncertainty about a future payment on a floating rate loan.

Q3. An FRA is:

A)   the Futures Regulatory Administration.

B)   a Forward Riskfree Asset.

C)   a Forward Rate Agreement.

Correct answer is C)        

An FRA is a forward rate agreement.

Q4. A forward rate agreement (FRA):

A)   can sometimes be viewed as the right to borrow money at below-market rates.

B)   requires the long to pay cash to the short if the rate specified in the contract at expiration is below the current floating rate.

C)   generally uses a fixed reference interest rate.

Correct answer is A)

If the floating rate is above the rate specified in the agreement, the long position can be viewed as the right to borrow at below-market rates. Floating rates like LIBOR are used in FRAs. The long must pay the short only if the contracted rate at the expiration date is above the floating rate.

thanks

ding