Question 3

TJA Corp. is anticipating a need to borrow $10 million in three months time for a period of six months. Its banker, Bank of America has agreed to provide a 6-month, $10 million loan at LIBOR+0.5%. The 6-month LIBOR is now quoted at 3% pa.

Required

A. What target interest rates can TJA lock in using an FRA? Describe the hedging strategy that the company would follow.

B. Show that the target interest rate locked in by the company is the same, irrespective of whether the 6-month LIBOR rate at expiration is 4% or 2%. Assume a counterparty and be specific about the terms.