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Sunwin Ltd manufactures audio equipment

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Sunwin Ltd manufactures audio equipment. The company wishes to borrow £8 million loan. The loan will be used to finance the research and development expenditure for a new range of high specification audio speakers for cars. The lending bank will fix the interest rate for the loan period at its prevailing lending interest rate when the loan is taken out. The chief financial officer of Sunwin Ltd is concerned about the uncertainty on the future interest rate. Future interest rate movements may affect the operating results and financial condition of the company. He is now worried that interest rates may increase over the next twelve months and would like to protect the company against interest rate risk. He believes that the lending interest rate on the six-month loan is likely to be as low as 4% per annum and he is concerned that the interest rate could be as high as 6% per annum. Interest on the loan would be payable at the end of the loan period. The chief financial officer would like to investigate how it might hedge against any unexpected increases in interest rates arising from the future short-term borrowing. The company’s banker has suggested using a Forward Rate Agreement (FRA) to protect the borrowing from adverse movements in interest rates. He approached the company's bank to obtain quotes for the borrowing of £8 million, covering a period of six months in three months’ time. The bank has offered a 3-9, 4%-5% forward rate agreement.

Required: a) Describe the characteristics of a forward rate agreement and demonstrate how a forward rate agreement can be used to manage interest rate risk. (Word limit: maximum 300 words)

b) With reference to the information provided, assess the merits of the proposed forward rate agreement as a risk management strategy by Sunwin Ltd to manage its exposure to any adverse interest rate movements. Provide relevant calculations to support your assessment.

c) Explain how forward rate agreements differ from interest rate futures. (Word limit: maximum 300 words)