QUESTION 3

Peet Ltd. is an Australian real estate development company, which has multiple projects across Australia. The company is intending to borrow $ 200,000,000 to fund its new residential property project in Paramatta, Sydney, which includes houses, units, flats, lagoons and more. The top management is concerned that the interest rate might increase following federal government decree to ease social restrictions in Australia. As an external financial advisor, you have been consulted to advise Peet Ltd. on its new projects fund.

REQUIRED:

1. From experience you know that, among other options, Forward Rate Agreement (FRA) is probably the most suitable option for Peet Ltd. Explain to the companys executives what is meant by the Forward Rate Agreement (FRA) and how the company can benefit from utilising this option?

[4 marks]

2. Following your advice, Peet Ltd. has entered into an FRA agreement with Alpha Ltd. in which Peet Ltd. borrows $ 200,000,000 in 3-month time for a period of 6 months, and Alpha Ltd. invests $ 200,000,000 in 3-month time for a period of 6 months. The 3-month interest rate is 1.5% per annum and the 6-month interest rate is 3.5% per annum.

1. What is the interest rate that both companies locked in?

[1 mark]

2. Suppose that on the expiry date of the FRA, the 3-month interest rate is 1.75% per annum and the 6-month interest rate is 4% per annum, calculate the compensatory payment and state which party receives it?

[2 marks]

3. Suppose that on the expiry date of the FRA, the 3-month interest rate is 1.25% per annum and the 6-month interest rate is 3% per annum, calculate the compensatory payment and state which party receives it?

[2 marks]

QUESTION 3 (continued)

3. Describe to Peet Ltd. how to make use of interest rate swap. Outline the differences between interest rate swap and FRA, and which agreement is more suitable to the company.

[3 marks]

(4 + 5 + 3 = 12 marks)