A large proportion of a Bank A security portfolio, which is worth $2 million in market values, is maturing in three months'

time. The bank plans to re-invest the proceeds in 180-day commercial papers. The bank's managers are concerned that market

interest rates are falling.

(i)

Should Bank A buy or sell Forward Rate Agreements (FRAs) to hedge this risk and why?

(li) Assume Bank A enters into a 180-day FRA contract (FRA rate = 10%) to hedge its interest rate risk. On the settlement

day, the reference (floating) rate has risen to 11%. Will Bank A gain or lose on this FRA? Calculate the compensation

payment in dollar terms (show all workings).

(ili) Explain whether or not Bank A has successfully hedged its interest rate risk with the FRA contract.