optiix

The short in a forward rate agreement:

A) faces default risk.

B) profits if LIBOR decreases.

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

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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.

optiix

Which of the following statements regarding forward rate agreements (FRAs) is least accurate?

A) Because the cash payment will happen in the future, the forward interest rate reflects the creditworthiness of the party which is long the FRA.

B) If the floating rate at contract expiration is greater than the rate specified in the FRA, the long position will receive a payment.

C) If the floating rate at contract expiration is less than the rate specified in the FRA, the right to lend at rates higher than market rates has a positive value.

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A forward rate agreement can be viewed as a forward contract to borrow or lend money at a certain rate at some future date. Because no actual loan is made at the settlement date, the forward interest rate does not need to reflect the creditworthiness of the parties to the contract (however, the parties may still face default risk).
If the floating rate at contract expiration is above the rate specified in the forward agreement, 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. If the reference rate at the expiration date is below the contract rate, the short can be viewed as the right to lend at rates higher than market rates.

optiix

The following data applies to a forward rate agreement that settles in 60 days:

• It is based on 180-day LIBOR
• The notional principal amount is $15 million
• It calls for a forward rate of 6.5%
• In 30 days, 180-day LIBOR will be 6.2%
• In 60 days, 180-day LIBOR will be 7.0%
• In 180 days, 180-day LIBOR will be 7.5%

The short’s cash payment at settlement is closest to:

A) $37,500.

B) the short will not have to make a payment.

C) $36,232.

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Settlement payment from short = notional principal × ((forward LIBOR at settlement − agreed forward rate) × (180/360)) / (1 + (floating × 180/360))
Payment = $15 million × ((7.0% − 6.5%) × (180/360)) / (1 + (0.07 × 180/360))
Payment = $36,231.88

optiix

A 60-day $10 million forward rate agreement (FRA) on 90-day London Interbank Offered Rate (LIBOR) (a 2X5 FRA) is priced at 4%. If 90-day LIBOR at the expiration date is 4.1%, the long:

A) receives $2,474.63.

B) receives $2,500.00.

C) pays $2,474.63.

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[(0.041 − 0.040)(90/360)(10,000,000)] / [1 + 0.041(90/360)] = $2,474.63.

optiix

Consider a $1 million 90-day forward rate agreement based on 60-day London Interbank Offered Rate (LIBOR) with a contract rate of 5%. If, at contract expiration, 60-day LIBOR is 6%, the short must pay:

A) $1,652.89.

B) $1,650.17.

C) $1,666.67.

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[(0.06 − 0.05)(60 / 360)(1,000,000)] / [1 + 0.06(60 / 360)] = 1,650.17.

optiix

When calculating the settlement payment on a long position in a London Interbank Offered Rate (LIBOR)-based forward rate agreement, the denominator is best described as:

A) a discount factor based on the contract LIBOR rate.

B) the interest differential between a loan made at the contract rate and one made at the market rate at contract expiration.

C) a discount factor based on LIBOR at settlement.

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Since the interest differential between a loan made at the contract rate and one made at the market rate would be realized at the end of a loan period beginning at the settlement date, it must be discounted to get the value at the settlement date. The correct rate for this discounting is the actual rate (market rate) at the settlement date. The interest differential is the numerator of the formula for calculating the settlement value.

optiix

When calculating the settlement payment on a long position in a London Interbank Offered Rate (LIBOR)-based forward rate agreement, the denominator is best described as:

A) a discount factor based on the contract LIBOR rate.

B) the interest differential between a loan made at the contract rate and one made at the market rate at contract expiration.

C) a discount factor based on LIBOR at settlement.

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Since the interest differential between a loan made at the contract rate and one made at the market rate would be realized at the end of a loan period beginning at the settlement date, it must be discounted to get the value at the settlement date. The correct rate for this discounting is the actual rate (market rate) at the settlement date. The interest differential is the numerator of the formula for calculating the settlement value.

optiix

A currency forward contract:

A) requires a payment at settlement based on London Interbank Offered Rate.

B) can be a deliverable contract.

C) is priced using the future interest rate on a foreign currency.

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A currency forward contract can be a deliverable or cash-settlement contract. It is a contract to exchange fixed amounts of two currencies at settlement and its value depends on market exchange rates at contract expiration.

optiix

An agreement that requires the parties to exchange a certain amount of Yen for a certain amount of Euros on a specific date in the future is called a(n):

A) exchange rate agreement.

B) currency forward contract.

C) foreign exchange future.

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Such an agreement is called a currency forward contract.

optiix

Which of the following statements regarding currency forward contracts is least accurate?

A) A long position in a currency that appreciates more than expected over the term of the contract will have a positive value at contract expiration.

B) If the domestic currency appreciates over the term of the contract, the party that is long the foreign currency will have losses on the contract.

C) Currency forward contracts can be settled in cash or by delivery.

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The forward exchange rate in the contract will reflect the expected appreciation or depreciation of the currency. If a currency appreciates by more than the expected appreciation implicit in the forward exchange rate, the party that is long that currency will have gains. An appreciation of one currency does not equate to gains to the party that is long that currency; if it appreciates by less than the appreciation reflected in the forward exchange rate, the long will have losses.