Two companies ABC Ltd. and XYZ Ltd. approach the DEF Bank for FRA (Forward Rate Agreement). Both companies want to borrow a sum of ₹ 100 crores…

7. (i) The difference in yield curve may due to the lower credit rating of ABC Ltd. compared to XYZ Ltd. (ii) DEF Bank will fix interest rate for 2V3 FRA after 2 years as follows: XYZ Ltd. (1+r) (1+0.0420)² = (1+0.0448)³ (1+r) (1.0420)² = (1.0448)³ r = 5.04% Bank will quote 5.04% for a 2V3 FRA. ABC Ltd. (1+r) (1+0.0548)²= (1+0.0578)³ (1+r) (1.0548)² = (1.0578)³ r = 6.38% Bank will quote 6.38% for a 2V3 FRA. (iii) Interest payable by XYZ Ltd. under two scenarios will be computed as follows: 4.50% Option allowed to be lapsed 5.50% is Option to Exercised Interest ₹ 100 crores X 4.50% ₹ 4.50 crores ₹ 100 crores X 5.04%* - ₹ 5.04 crores Premium (Cost of Option) ₹ 100 crores X 0.10% ₹ 0.10 crores ₹ 0.10 crores ₹ 4.60 crores ₹ 5.14 crores * Since after 2 years 1 year interest rate turned out to be 5.50%, it will be beneficial for XYZ Ltd. to exercise its option.