This problem is asking you to evaluate the Forward Rate Agreement.

Firenza Motors $($Italy$).$ Firenza Motors of Italy recently took out a $4-$year, $5$ million loan on a floating

rate basis. It is now worried, however, about rising interest costs. Although it had initially believed

interest rates in the eurozone would be trending downward when taking out the loan, recent

economic indicators show growing inflationary pressures. Analysts are predicting that the European

Central Bank will slow monetary growth, driving interest rates up$.$

a$.$ Firenza is now considering whether to seek some protection against a rise in euro$-$LBOR and

is considering a forward rate agreement $($FRA$)$ with an insurance company. According to the

agreement, Firenza would pay to the insurance company at the end of each year the

difference between its initial interest cost at LIBOR $+2\mathrm{.}50\%(6\mathrm{.}50\%)$ and any fall in

interest cost due to a fall in LBOR. Conversely, the insurance company would pay to Firenza

$70\%$ of the difference between Firenza's initial interest cost and any increase in interest costs

caused by a rise in LBOR. LIBOR is currently $4\mathrm{.}00\%.$

b$.$ Purchase of the floating rate agreement will cost $100,000,$ paid at the time of the initial loan.

What are Firenza's annual financing costs now if LBOR rises and if LBOR falls in increments

of $0\mathrm{.}5\%?$ Firenza uses $12\%$ as its weighted average cost of capital. Do you recommend that

Firenza purchase the FRA?

Once you know the rates each year, your job is to create cash flows for the loan. If Libor falls, the cash flows on the loan would look like:

IfLBOR Falls $50$ Basis Pts Per Year

Finally, look at the situation and decide whether the FRA is a good idea for Firenza. Your understanding of whether this is a good deal is worth $5$ points.