Cagle Manufacturing forecasts a cash inflow of $10 million in two months that it is considering investing in a Sun National Bank CD for 90 days. Sun National Bank’s jumbo CD pays a rate equal to the LIBOR. Currently such rates are yielding 5.5% (annual rate with an actual/365 day-count convention). Cagle is concerned that short-term interest rates could decrease in the next two months and would like to lock in a rate now. As an alternative to hedging its investment with Eurodollar futures, Sun National suggests that Cagle hedge with a Forward Rate Agreement (FRA).

a. Define the terms of the FRA that would effectively hedge Cagle’s futures CD investment.

b. Show in a table the payoffs that Cagle and Sun National would pay or receive at the maturity of the FRA given the following LIBORs: 5%, 5.25%, 5.5%, 5.75%, and 6%.

c. Show in a table Cagle’s cash flows from investing the $10M cash inflow plus or minus the FRA receipts or payments at possible LIBORs of 5%, 5.25%, 5%, 5.75%, and 6%. What is the hedged rate of return Cagle would earn from its $10 million investment?