Explanation:
By convention, an FRA is usually settled at the beginning of the period covered by the FRA. The settlement amount is the present value of the difference in interest amounts with the discount rate being the floating rate. Therefore, the cash flow under the FRA must be discounted back to the beginning of the quarter.
Fixed rate payment per quarter = 0.25 × 0.0225 × EUR 10,000,000 = EUR 56,250
Floating rate payment at the one year date = 0.25 × 0.018 × EUR 10,000,000 = EUR 45,000
Net cash flow = EUR 56,250 - EUR 45,000 = EUR 11,250 (payment by fixed rate payer)
Payment must be discounted at the floating rate: EUR 11,250 / (1 + 0.018/4) = EUR 11,250 / (1 + 0.0045) = EUR 11,250 / 1.0045 = EUR 11,200
Therefore, the correct cash flow required today to settle the FRA is EUR 11,200.
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An analyst at Bank FLR is calculating the cash flows on a forward rate agreement (FRA) that the bank entered into 1 year ago. The bank is a fixed rate payer under the FRA and the terms of the FRA state that interest accrues for the 3-month period beginning 1 year after initiation. The analyst collects the following information about the FRA and interest rates in the market:
What is the amount of the cash flow required today to settle the FRA?
A
EUR 4,975
B
EUR 5,000
C
EUR 11,200
D
EUR 11,250