Suppose that the 3 month and 6 month continuously compounded LIBOR rates are 3% and 3.5% respectively. Assume that LIBOR is used as the risk-free discount rate.
a) What is the value of an FRA under which 4% is paid and LIBOR is received on $10 million for the period? Assume that these rates are quarterly compounded.
b) Consider a company which plans to borrow in the future and fears that short term rates would rise. The company would like to hedge its interest rate risk by using an FRA. Should it purchase or sell the FRA?