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The treasurer of a small bank has borrowed funds for 1 month at an interest rate of 3% and has lent funds for 3 months at 4%. The treasurer borrowed and lent 2 million dollars in t0.
a. Represent the exposure on cash flow diagrams. Be specific on the size of the cash flows in each period.
b. Assume that the treasurer decides to wait 1 months and take a spot loan then. To cover his exposure, the treasurer signs a 1x3 FRA. (i) Use cash flow diagrams to show how this achieves his goal. Be specific on the size of the cash flows for each period (except the floating amounts, which depend on the Libor at t1). (ii) What is the settlement amount in the FRA if the forward rate is 3.5%, the Libor rate on settlement date is 4%? (iii) Now that you know the Libor rate, use it to determine the exact outflows and inflows in t2.
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