Sue Wie, CFA, is the chief financial officer for Garth Company. The company will need to borrow S75 million in the near future to fund a plant expansion. Wie expects interest rates will rise and decides to hedge against this risk using a 3 * 6 LIBOR based forward rate agreement (FRA). The underlying rate for this FRA is:
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A. B. C.Explanation
To determine the underlying rate for the 3 * 6 LIBOR based forward rate agreement (FRA), we need to understand the structure and mechanics of an FRA.
A forward rate agreement (FRA) is a financial derivative contract between two parties, where one party agrees to pay a fixed interest rate and the other party agrees to pay a floating interest rate based on a specified reference rate. In this case, the reference rate is LIBOR (London Interbank Offered Rate).
The notation "3 * 6" in the 3 * 6 LIBOR FRA refers to the time period for which the FRA is being entered into. The first number represents the number of months from the current date when the FRA is initiated, and the second number represents the number of months after the initial period when the settlement occurs.
So, in this case, the FRA is entered into for a period of 3 months (90 days) and the settlement occurs after 6 months (180 days).
Now, to determine the underlying rate for the FRA, we need to look at the specific interest rate that the fixed rate payer will pay and the floating rate payer will receive. In an FRA, the fixed rate is typically set equal to the forward rate, which is an estimated rate of interest to be determined at a future date.
Since Sue Wie, CFA, expects interest rates to rise, she wants to hedge against this risk. To do so, she will enter into a 3 * 6 LIBOR based FRA. In this case, the underlying rate for the FRA will be based on the future expectation of the 6-month LIBOR rate.
Therefore, the correct answer is C. 180-day LIBOR, as the underlying rate for the 3 * 6 LIBOR based FRA is the future expectation of the 6-month LIBOR rate.