Matthew enters into a forward rate agreement (FRA)with the local bank.The current one-year forward rate is 4%.If the yield on a one-year T-Bill in one year is 3.5%, what payment will be made to settle the agreement?
A)Matthew would pay the bank 0.5%.
B)Matthew will use the market rate rather than the FRA rate.
C)The bank would pay Matthew 0.5%.
D)Matthew would not exercise his option.

Question

Quizplus · Accepted Answer

Since Matthew entered into a FRA with a fixed rate of 4%, he is assuming that the interest rates will be higher in the future. However, if the yield on a one-year T-Bill in one year (i.e., the market rate) is only 3.5%, Matthew would be better off not exercising his option and just borrowing at the market rate. Therefore, he would have to compensate the bank for the difference between the FRA rate and the market rate, which is 0.5%. Thus, the answer is A.

Matthew Enters into a Forward Rate Agreement (FRA)with the Local