Suppose you need to pay $1M to finance a project in 6 months. Bank ABC will provide a one year loan with the amount of $1M in 6 months and bank XYZ offers a 6month-18month FRA (i.e., the FRA is for a contract period of 12 months starting in 6 months) with notional value of $1M and forward rate r0, 6mth, 18mth = 12% (simple interest rate).
a) What should you do to hedge your borrowing cost?
b) Suppose the one year simple interest rate in 6 months rises to 14%. How much money do you owe Bank ABC in 18 months? When and how much money will you pay/receive from bank XYZ? What is your actual cost of borrowing?
c) Redo part (b) assuming the one year simple interest rate drops to 9% in 6 months.
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