Provide an Interest Rate Swap, Future and Option numerical example and explain your results in detail.

(6 Marks)

Morson Plc has a 4.4% cost of capital and recently took out a 3-year $18.5 million debenture loan from New York on a LIBOR floating rate basis. However, it now believes that LIBOR is likely to increase and so they are considering whether to take out a Forward Rate Agreement (FRA) with the Liverpool Victoria Insurance Company as a form of hedge, costing $1.25m payable at the beginning of the first year.

According to the proposed agreement, the Liverpool Victoria Insurance Company would pay Morson 92% of the difference between Morsons initial interest cost and any increase in interest costs caused by a rise in LIBOR.

Conversely, Morson would pay the Liverpool Victoria Insurance Company the difference between its initial interest cost at LIBOR + 1.75% (where LIBOR is currently at 1.25%) and any fall in interest cost due to a fall in LIBOR at the end of each year.

Required:

(b) Determine whether you would recommend that Morson should purchase the FRA by showing a 3 year forecast for a protentional increase and decrease in LIBOR by 25 basis points.

(13 Marks)

(c) Differentiate in detail between a FRA and an Interest Rate Future that could be used to hedge interest rate exposure for Morson.

(6 Marks)