It is March. A firm signs an agreement to invest in a wealth management product. With a purchase price of 20 million in 3 months. The product is a 6 month floating rate money market instrument. The interest rate of the product is determined by the 6 month LIBOR rate when the agreement starts. Upon expiration mid-December, the product make a lump sum payment to its buyer, which includes both the principal amount (I.e. 20 million) and the interest income. There is NO interim cash flows from the product before the expiry date.
Right after signing the purchase agreement, the firm starts to worry about future interest rates. Note the firm’s operational expenses are fixed over time. An increase or decrease in market interest rate will NOT lead to an increase or decrease in its expenses. However the treasurer of the firm is concerned about the unexpected interest rate movement that might decrease the firm’s revenue (i.e., lower interest income) and proposes to the CEO to hedge the interest rate risk by using FRA contracts. Suppose the following FRAs are available in the marked in mid-March. The principal amount is $20 million for all the FRAs. All FRAs are the standard US FRAs.

FRA Contract	Rate(p.a)
1x6	4.8%
2x6	5.0%
3x6	5.2%
1x9	5.0%
2x9	5.2%
3x9	5.4%

*The rates are simple rates

Question part 1: Which FRA contract is MOST appropriate for hedging against the interest rate risk for the firm and why? Also explain whether to short or long the FRA contract.

Question part 2: Then, suppose the firm fully hedges the interest rate risk using the most appropriate FRA contract. Use calculations to explain whether the firm make a profit or loss on the FRA contract if the 6 month LIBOR rate is 4% per annum in mid-June. (ignore the day count convention, and assume that one-, two-, month corresponds to 1/12, 2/12..of a year) when using LIBOR rates and FRA rate in calculating the settlement amount.

Question part 3: Suppose the CEO rejects the proposal to use FRAs to hedge, and said "hedging is costly and unnecessary for us, and it's not needed even if market interest rates drops sharply after March 1st." Explain whether his judgement is justified or not in a short paragraph.

Jamie Lee Jackson, age 27, full-time student and part-time bakery employee, has just moved into a bungalow-style, unfurnished home of her own. The house is only a one-bedroom, but the rent is manageable and has plenty of room for Jamie Lee. She decided to give notice to her roommate that she would be leaving the apartment and the shared expenses after the incident with the stolen checkbook and credit cards a few weeks back. Jamie had to dip in to her emergency savings account to help cover the deposit and moving expenses, as she had not planned to move out of the apartment and be on her own this soon. Jamie is in need of a few appliances, as there is a small laundry room, but no washer or dryer, nor is there a refrigerator in the kitchen. She will also need a living room set and a television because the only furniture she currently has is a bedroom suite. Jamie is so excited to finally have the say in how she will furnish the bungalow, and she began shopping for her home as soon as the lease was signed. The home appliance store, Acme Home Goods, was the first stop as Jamie chose a stacking washer and dryer set, which would fit comfortably in the laundry space provided. A stainless steel refrigerator was her next choice, and the salesperson quickly began to write up the order. Jamie was informed that if she opened up a credit card through the appliance store that she would receive a discount of 10% off her total purchase. As she waited for her credit to be approved, she decided to continue shopping for her other needed items. Living room furniture was next on the list as Jamie went to the local home furnishings retailer who had endless choices of complete sofa sets that included the coffee and end tables as well as matching lamps. Jamie chose a contemporary-style set and, again, was offered the tempting deal of opening a credit card through the store in exchange for a percentage off her purchase and free delivery. On to the big box retailer where Jamie then chose a 52" 1080p LED HDTV. For the third time, a percentage off her first purchase at the big box retailer was all that was needed to get Jamie to sign on the dotted line of the credit card application. Jamie Lee wants to determine if she can afford the monthly payments for all of her purchases before she completes the application process. Use the information below to determine her debt payment-to-income ratio. Current Financial Situation Assets: Checking account Savings account Emergency fund savings account IRA balance Car Liabilities: Student loan $11,800 (Jamie is still a full-time student, so no payments are required on the loan until after graduation) Acme Home Goods (Washer/dryer and refrigerator) Local Home Furnishings (Sofa set) Big Box Store (52" LED HDTV) Income: $2,300 Gross monthly salary $8,200 Net income $3,700 Monthly Expenses: $510 Rent obligation $3,800 Charge Accounts and Credit Cards Financial Institution or Description Totals Debt payment-to-income ratio Utilities/Electric Utilities/Water Utilities/Cable Account Number Food $2,050 Acme Home Goods Automobile, Education, Personal, and Installment Loans Financial Institution or Account Number Description Student loan Gas/Maintenance Credit card payment $2,150 Local Home Furnishings $1,550 Big Box Store Total monthly debt payments. Net (after-tax) income Current Balance Acme Home Goods Local Home Furnishings Big Box Store Other Loans (Overdraft Protection, Home Equity, Life Insurance Loan) Financial Institution or Account Number Current Balance Description Current Balance. $3,250 $2,275 $450 $60 0 $ $35 $50 $175 $180 $0 $49 $62 $37 Monthly Payment Monthly Payment Monthly Payment 0