A large proportion of Lerby Banks 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 banks managers are concerned that market interest rates are falling.

(i) Should Derby Bank buy or sell Forward Rate Agreements (FRAs) to hedge this risk? (2 marks)

(ii) Assume Derby Bank enters into a 180-day FRA contract (FRA rate = 10% per annum) to hedge its interest rate risk. On the settlement day, the reference (floating) rate has risen to 11% per annum. Will Derby Bank gain or lose on this FRA? Calculate the compensation payment in dollar terms. (5 marks)

(iii) Explain whether or not Derby Bank has successfully hedged its interest rate risk with the FRA contract. (3 marks)