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Forward Rate Agreements

A forward rate agreement (FRA) is an over-the-counter interest rate derivative contract where one party agrees to pay a fixed interest rate and receive a floating interest rate on a notional principal amount at a future settlement date. FRAs are used by parties to hedge against future interest rate changes. At maturity, the difference between the contracted fixed rate and the market reference rate is exchanged, rather than actual funds.

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Amul Shrestha
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301 views6 pages

Forward Rate Agreements

A forward rate agreement (FRA) is an over-the-counter interest rate derivative contract where one party agrees to pay a fixed interest rate and receive a floating interest rate on a notional principal amount at a future settlement date. FRAs are used by parties to hedge against future interest rate changes. At maturity, the difference between the contracted fixed rate and the market reference rate is exchanged, rather than actual funds.

Uploaded by

Amul Shrestha
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Forward Rate Agreements

Forward Rate Agreement (FRA) is a forward contract between two parties to exchange an interest rate differential on a notional principal amount at a given future date in which one party agrees to pay a fixed interest payment at a quoted contract rate and receive a floating interest payment at a reference rate (Underlying rate). FRA transactions are entered as a hedge against interest rate changes. At maturity, no funds exchange hands; rather, the difference between the contracted interest rate and the market rate is exchanged

Forward Rate Agreements


Characteristics :
an forward contract of interest rate. One party makes a fixed interest payment. The other party makes an interest payment based on a referenced rate at the time of contract expiration. The underlying is an interest rate. Payments are based on the difference between the contract rate and the reference rate (e.g., LIBOR).

Forward Rate Agreements


The buyer of a FRA receives the settlement amount
He agrees to pay a fixed rate payment and receive the floating rate payment. He want to protect itself from a future increase in interest rate.

The seller of a FRA pays the settlement amount


He agrees to pay a floating rate payment and receive a fixed rate payment. He want to protect itself from a future decline in interest rate

Forward Rate Agreements


Computation: M * (ir - ig ) * N/360 1+ ir * N/360
Notation
M : notional principal ir : reference rate (market rate) ig: FRA contract rate (fixed rate) N : duration (period of the reference rate)
N = dt-de with : dt : maturity date of underlying FRA contract de : settlement date of FRA contract

Forward Rate Agreements


Description
Example (use the preceding example)
The firm negotiates the following FRA (it sells the FRA) :
Notional : $1000 000 Reference rate : 6-month Libor FRA contract Rate : 4% d : in 3 months dt : in 9 months Duration : 6 months

Forward Rate Agreements


Description
Example (use the preceding example)
Hypothesis : in 3 months, the 6-month Libor is 5%
Firm pays the interest rate differential. Payoff

180 0,05 0,04 360 M 1000000 180 1 0,05 360 M 4878,05

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