The short in a forward rate agreement: A) profits if London Interbank Offered Rate (LIBOR) increases. B) profits if LIBOR decreases. C) faces default risk. D) must borrow money at the contract rate at settlement.
B looks correct, but does it have to do with extent of decrease. is C the ans ?
is it C?
C both long and short position face default risk
I chose B, FRA act like a long/short call.
The answer is C. Default risk exists always. But the short will benefit from falling LIBOR only if LIBOR in the FRA is higher than the LIBOR at contract expiration… I was also confused with this description. If 180-day LIBOR today is 5% and I am anticipating that the 180-day LIBOR is going to increases to 6% in another 90 days, I enter into a 90 day FRA to lock that 6%. If the 180-day LIBOR at the contract expiration is 5.5%, the short is going to benefit from it. In this case the LIBOR is decreasing. If the 180-day LIBOR today is 5% and in anticipation of decrease in 180-day LIBOR to 4% in another 90 days I enter into a 90 day FRA locking that 4%. If the 180-day LIBOR at the contract expiration is 4.5%, then the short is not benefiting from the contract. In this case the LIBOR increased from the contracted rate even though overall movement is a decrease in the LIBOR.