Forward Rate Agreement

INTRODUCTION:A forward rate agreement (FRA) is a forward contract, an overthe-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used along with the termination date and notional value. On this type of agreement, it is only the differential that is paid on the notional amount of the contract. It is paid on the effective date. The reference rate is fixed one or two days before the effective date, dependent on the market convention for the particular currency. FRAs are over-the counter derivatives. A FRA differs from a swap in that a payment is only made once at maturity. Rationale:Many banks and large corporations will use FRAs to hedge future interest rate exposure. The buyer hedges against the risk of rising interest rates, while the seller hedges against the risk of falling interest rates. Other parties that use Forward Rate Agreements are speculators purely looking to make bets on future directional changes in interest rates. In other words, a forward rate agreement (FRA) is a tailor-made, over-the-counter financial futures contract on short-term deposits. A FRA transaction is a contract between two parties to exchange payments on a deposit, called the Notional amount, to be determined on the basis of a short-term interest rate, referred to as the Reference rate, over a predetermined time period at a future date. FRA transactions are entered as a hedge against interest rate changes. The buyer of the contract locks in the interest rate in an effort to protect against an interest rate increase, while the seller protects against a possible interest rate decline. At maturity, no funds exchange hands; rather, the difference between the contracted interest rate and the market rate is exchanged. The buyer of the contract is paid if the reference rate is above the contracted rate, and the buyer pays to the seller if the reference rate is below the contracted rate. A company that seeks to hedge against a possible increase in interest rates would purchase FRAs, whereas a company that seeks an interest hedge against a possible decline of the rates would sell FRAs.

FRA OBJECTIVES:In virtually every market worldwide, FRAs trade under a set of terms and conventions that are identical. The British Bankers Association (BBA) has compiled standard legal documentation to cover FRA trading. The following standard terms are used in the market. Notional sum: The amount for which the FRA is traded. Trade date: The date on which the FRA is dealt. Settlement date: The date on which the notional loan or deposit of funds becomes effective, that is, is said to begin. This date is used, in conjunction with the notional sum, for calculation purposes only as no actual loan or deposit takes place. Fixing date: This is the date on which the reference rate is determined, that is, the rate to which the FRA dealing rate is compared. Maturity date: The date on which the notional loan or deposit expires. Contract period: The time between the settlement date and maturity date. FRA rate: The interest rate at which the FRA is traded. Reference rate: This is the rate used as part of the calculation of the settlement amount, usually the LIBOR rate on the fixing date for the contract period in question. Settlement sum: The amount calculated as the difference between the FRA rate and the reference rate as a percentage of the notional sum, paid by one party to the other on the settlement date.

METHODOLOGY:An FRA is very similar to a futures contract. It is an agreement between two parties regarding the value or level of a financial instrument at a future date. Unlike futures, FRAs are not traded on an exchange (This is called OTC, or Over The Counter). Forward Rate Agreements are infinitely more flexible, as they can be structured to mature on any date. In general FRAs are traded on the future level of 3 or 6 month Libor. The FRA does not involve any transfer of principal. It is settled at maturity in cash, representing the profit or loss resulting from the difference in the agreed rate (FRA rate) and the settlement rate at maturity. A Forward Rate Agreement (FRA) gives an institution the ability to fix interest rates for periods in the future. A hedge against future values of LIBOR.

CHARACTERISTICS OF FRA'S
A FRA is an Off Balance Sheet instrument. Unlike the Cash Deposit market there is no delivery of Capital only the differential between the contract rate and the settlement rate. Any trade entered into does not appear as an asset or liability.

FRA's in use
Bank A has a commitment that requires borrowing Y 10 Billion from the cash market in two months time for a period of three months. It is concerned over the possibility of an interest rate rise within that two month period.

Strategy using an FRA

Bank A decides to hedge the risk of an interest rate rise by buying a three month FRA (90 days). It asks the Broker for a price in a 2 X 5 (Two by five). The Broker quotes 8.50-8.45%. Bank A pays the offer at 8.5 % and deals with the counterparty Bank B The value date is two months from spot date. First fixing is two business days prior to the value date. Maturity will be three months from the value date.

Interest rate rise scenario

Two months later, on the fixing date, 3m LIBOR is set at 9.00% in line with Bank A's expectations.

When Bank A funds itself in the cash deposit it will have to pay 9.00% . However Bank A bought a FRA at 8.50% and with 3m LIBOR set at 9.00% it realizes 0.50% profit. Bank A will receive the differential between the contract rate and LIBOR setting from Bank B. The real cost of funding is 8.50%.

Interest Rate fall scenario

Two months later, on the fixing date, LIBOR is set at 8.00% against Bank A's expectations. Bank A funds itself at 8.00%. However it must pay the differential of 0.50% between the LIBOR setting and the contract rate to Bank B. The real cost of funding is 8.50%. If Bank A is reluctant to commit itself to a specific rate with the obligation to pay or receive funds depending on the LIBOR setting, it may decide to purchase an IRG (Option on a FRA) which confers the right but not the obligation to deal at a specified rate. Unlike cash deposits where interest is paid on maturity FRA's are discounted by the settlement rate and the differential is paid on the value date.

Calculation of profit and loss

Calculation formula ((LIBOR-FRA RATE) x FRA DAYS x AMOUNT / (360 x 100 + (LIBOR x FRA DAYS)) = COST ((9.00-8.50)x90x100 Billion)/(360x100+(9.00x90))=12,224,938.87=12,224,939 Profit This is the profit from buying the FRA. This profit lowers the funding cost to 8.50%. However if Bank A wished to make a perfect hedge it must include this amount in its cash deposit funding to counterbalance the effect of discounting.

ANLAYSIS OF FRA:FRA's and Financial Futures; A comparison. 1.TENOR

Futures / 3m (TIFFE/ SIMEX) and 1year (TIFFE only) IMM dates only. FRA's / Usually 3m, 6m,9m and 1 year. Dates are flexible.

2.AMOUNT

Futures / 1 Contract Y100 million. No maximum number of contracts. FRA's / Usually Y5 to Y10 Billion. No maximum but the practical minimum is Y1Billion.

3.MARKET PARTICIPANTS

Futures / Any Party qualified under Exchange regulations. FRA's / Banks, Investment Banks and other authorized financial institutions.

4.REPORTING

Futures / The Account is revalued everyday the position reported to the Exchange and any margin obligations must be discharged FRA's / No daily position reporting or margin requirements.

5.CREDIT RISK

Futures / All risk covered by Exchange guarantees. FRA's / Credit risk exists but only on the interest rate differential. No Capital or Interest on that Capital is at risk

6. MARKET CONVENTIONS

Spot start FRA's

Tenor dates follow the Eurodeposit markets but start dates are flexible.. For example; A 2 X 5 (Fixing 3m interest rate in 2 months time) transacted on 6/01:

TENOR SPOT FIXING DATE VALUE DATE MATURITY

DATE DETAILS 6/03 Two business days after the transaction date Two days prior to value date. Also known as 8/01 determination or settlement date. The start date of the FRA. Funds transferred on this 8/03 date 11/03 End of FRA. For calculation purposes only.

The diagram shows that the counterparties are trading 3m LIBOR value 3rd August. It is impractical to insist on delivery of funds on the same day as the rate is fixed, particularly if the counterparties are in different timezones, therefore spot value convention of two business days is followed. The Spot value and Maturity convention maintains that Bank and National holidays in the traded currency do not count as business days. This may also include holidays in London and New York depending on the counterparties agreement. However the fixing date is only affected by holidays in London. If theTokyo Market is closed and London is open LIBOR rates are issued and this will be a valid fixing date.

Odd

Odd (irregular) start date FRA's are also common. Start dates.in particularly strong demand from Corporates are month , fiscal year and calendar year end. The Arbitrage opportunities with financial futures create strong demand for odd dates in the OTC market to match the fixed IMM dates. 3 MONTH 6 MONTH MAIN INSTRUMENTS 1x4 2x5 3x6 4x7 5x8 1x7 2x8 3x9 4x10 5x11 LESS ACTIVE 3 MONTH 6 MONTH 1 YEAR 9x12 9x15 6x18 OTHERS 0x3 0x6 7x13 11x23 etc.. 12x15 12x18 15x18 18x24 12x24 6x9 6x12

The convention in the FRA market is that any start date following the spot date and within the same calendar month will be quoted as zero start. A spot start for a 3m FRA would be 0 x 3 "zero-threes over spot" any irregular start will be 0 X 3 over that date. For a start in the next calendar month the FRA will be a 1 x 4 "ones-fours" over the required date and so on 2 X 5 etc. Eighty percent of the FRA market is comprised of 3m and 6m tenors. Many other tenors ar possible but market demand is limited.For example 1m FRA's are traded but predominantly at the end of the fiscal year.

Inter-relationship with Futures (Pricing , Hedge, Arbitrage)

Each institution has its own custom designed method of Risk Management the following is a basic example of risk hedge using futures.

Scenario

On 20th May Bank A expected interest rates to rise. To counteract this it bought a 3m FRA start date 20th August. the Notional amount was Y10 billion. However Bank A was also concerned over the potential for interest rates to fall so at the same time it purchased futures. Futures trade as price so as interest rates fall their price will rise. If the FRA and IMM dates match the hedge is easy however in this case the spot start and IMM date do not match so to hedge Bank A must use two futures contracts.

Futures hedge

From the diagram it can be seen that June futures cover 1/3 of the FRA and September futures 2/3 of the FRA. There is a Ratio effect between September

and June futures of 2:1. To offset this effect the amount hedged in each futures contract is in the ratio of 2:1. In this case Bank A buys Y3.3 Billion June futures and Y6.7 September futures. While this is obviously not a perfect hedge the principles involved are the basis for some of the more complicated and exacting hedge techniques. Using sophisticated computer models it is possible to calculate a fair value for any FRA( Strip pricing). Arbitrage opportunities exist when this value is different from the futures actual price. Arbitrage with Eurodeposits

Possible Strategy

It is frequently possible to Arbitrage with the cash Eurodeposit market. For example; Borrow long term Eurodeposit funds, simultaneously lending short term Eurodeposit funds and selling a delayed start FRA matching the tenor of the long term Eurodeposit. While it is complicated to achieve, opportunities do exist in the market.

N.B.

The amount invested in the FRA must equal the total of Capital and Interest invested in the short term deposit. In the FRA market it is unlikely that a counterparty will agree to an exact amount it will prefer to deal in round sums of Y1 billion.

STARGETIES AND LIMITATIONS OF FRA:PRICING The FRA rate is the implied forward rate for that date. The value of the FRA will be dependent on the then market view of future rates. The shape of the yield curve is very important in establishing value. See the "Implied Forwards" section for more detail.

TARGET MARKET FRAs are an attractive instrument for both borrowers and investors who wish to take a view on the future level of short term interest rates. As they are date specific, they are an ideal instrument for hedging future rate settings on loans and financial assets. ADVANTAGES

Customized dates and amounts Very liquid market so small Bid/Offer spreads No premiums or payments upfront Can be reversed at any time at the then prevailing rate

DISADVANTAGES

Only cover short term interest rates

PRODUCT SUITABILITY Simple Aggressive

PAYOFF FORMULA
The netted payment made at the effective date are as follows

The Fixed Rate is the rate at which the contract is agreed. The Reference Rate is typically Euribor or LIBOR. is the day count fraction, i.e. the portion of a year over which the rates are calculated, using the day count convention used in the money markets in the underlying currency. For EUR and USD this is generally the number of days divided by 360, for GBP it is the number of days divided by 365 days. The Fixed Rate and Reference Rate are rates that should accrue over a period starting on the effective date, and then paid at the end of the period (termination date). However, as the payment is already known at the beginning of the period, it is also paid at the beginning. This is why the discount factor is used in the denominator.

FRAs Notation
FRA Descriptive Notation and Interpretation Notation 1x4 1x7 3x6 3x9 6 x 12 Effective Date from Termination Date from now now 1 month 1 month 3 months 3 months 6 months 4 months 7 months 6 months 9 months 12 months 18 months Underlying Rate 4-1 = 3 months LIBOR 7-1 = 6 months LIBOR 6-3 = 3 months LIBOR 9-3 = 6 months LIBOR 12-6 = 6 months LIBOR 18-12 = 6 months LIBOR

12 x 18 12 months

How to interpret a quote for FRA?

SUGGESTIONS:FRAs are usually used to protect the borrower against rising interest rates. The purpose of a FRA is to guarantee the future interest rate, and there is no direct link between the FRA and the underlying loan. Borrowers use FRAs to gain interest rate certainty on a portfolio of loans, while investors use them to protect asset portfolios from decreasing interest rates. Theory It is agreed at time 0 that an interest rate of RK will be paid on a principal P for the period

of time between T and T*. Let t = current time r = spot interest rate for maturity T ; r* = spot interest rate for maturity T*; R = JIBAR rate for the period [T, T*]. The FRA is an agreement to pay ( ) ( * ) r (T t ) K P R - R T -T e- - at time t.

CONCLUSION:A contract made directly between 2 parties (a seller and a buyer) fixing the interest rate (at settlement date) that will apply to a notional principal sum of money for an agreed future time period (maturity date) Such that at maturity date,

The FRA buyer: receives money from the seller if the reference benchmark interest rate is above the one agreed in the contract. The FRA seller: receives money from the buyer if the reference benchmark interest rate is bellow the one agreed in the contract.

The notional principal never changes hands. FRA should not be confounded with forward rate implied from yield to maturity bond. In that case there is no specific agreement and we dont talk about FRA.