A forward rate agreement is an over the counter derivative where two parties make a cash settlement based on interest rate differences. A forward rate agreement is a forward contact on a short-term interest rate, usually LIBOR, in which cash flow obligations at maturity are calculated on a notional amount and based on the.
Your email address will not be published. All fields are required. Forward rate agreements FRAs - definitions, examples and applications Tags: Very, very clear article, along with a solid example. Thank you very much Vijay, I'm really happy that you found this article helpful.
Thanks a lot Karim, will definitely try to add more articles about instruments as soon as possible. Very useful and clear article. Thanks a lot Marcia, I'm glad you found this article helpful. Its a breath of fresh air. Thanks MUZI, really pleased you liked this article!
Thanks a lot Maria, I'm very pleased that this article was of use to you. Thanks, very well explained. There is different FRA rate in the interest differential calculation than in the characteristics which is a bit confusing.
Hi Masa, you are absolutely right, nicely spotted. This has now been corrected. Hi Senad, thanks for your comment. This is now corrected. Clear and explicit explanation and example as well. Write a comment Your email address will not be published. The interest rate the two contracting parties negotiate on trade date.
Banks like FRAs because they have no capital adequacy requirements. The parties are classified as buyer and seller. By convention, the buyer of the contract, who wants a fixed interest rate, receives a payment if the reference rate is higher than the FRA rate; if lower, then the seller receives payment from the buyer.
The buyer is also sometimes referred to as the borrower and the seller is sometimes referred to as the lender , even though the notional principal is never lent. The dealing date is when the contract is signed.
The fixing date is the date when the reference rate is checked, then compared to the forward rate. For sterling, this is the same day as the settlement date, but for all other currencies, it is 2 business days prior. The reference rate is published by the stipulated organization, which is usually promulgated through Reuters or Bloomberg. Unlike most forward contracts, the settlement date is at the beginning of the contract period rather than at the end, since by then, the reference interest rate is already known, so the liability can be fixed.
Stipulating that the payment be made sooner rather than later reduces credit risk for both parties. Similarly, for a borrower, if you think that interest rate can rise in future, then you can take a long position in FRA contract to fix your interest payments at the current interest rates. This is very important to know the rationale behind the FRA positions.
Let us understand the notation of FRA first. If you enter into 2X5 FRA contract through a long position, then you are eliminating your risk that interest rate may rise in future. The profit or loss due to a position in a contract can be calculated by comparing the FRA rate with the market interest rate at the end of contract expiry. If the market rate is more than the FRA rate i. Similarly, if the market interest rate is lower than the FRA rate, then the long position will lose as he could have got the loan at a lower market interest rate.
To calculate the gain at the FRA contract expiration, we need to know the notional principal on which there was an agreement. Now, you need to pay that interest at the end of 3 months loan period. At the contract expiry, you will gain the present value of that amount and that have to be discounted at the current market rates. Then we have to calculate the value of FRA at different times: Let us try to understand the FRA valuation.
For a 1X4 FRA contract i. Then, the FRA rate will be based on arbitrage pricing i. So, both of these values should be equal. Similarly, we can calculate any FRA rate at any time. Now, the value of FRA contract will be zero for both the parties long and short at the contract initiation.
At the expiration, its value will depend on the interest rate for the loan period and that can be calculated simply as I had explained earlier. To calculate the FRA contract value in between contract initiation and contract expiry, our approach will be the same. Let us discuss it with an example.
Suppose in 1X4 FRA contract, we initiated the contract at 6.
And the present value of those savings i.
But he is afraid that the interest rates might rise in the coming future and he might get a loan at a higher interest rate. This adjustment is called futures convexity adjustment FCA and is usually expressed in basis points.