Forward Rate Agreements

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FORWARD RATE AGREEMENTS
 FORWARD RATE AGREEMENTS
EXPLANA
If we are
A is to enter int
ney. • A FRA is an agreement to borrow or lend a notional cash sum that at ti

ties: for a period of time lasting up to twelve months, starting at any will lend
at a rate
yer/
receiver
point over the next twelve months, at an agreed rate of interest time o y
then com
sition- (the FRA rate). The “buyer” of an FRA is borrowing a notional t-years w
when
e sum of money while the “seller” is lending this cash sum. Note market r
time so a
ng)
payer/
how this differs from all other money market instruments. In the would ha
from the
ceiver cash market, the party buying a CD or bill, or bidding for stock
osition-
when in the repo market, is the lender of funds. In the FRA market, to
e “buy” is to “borrow”.
ng)
USES OF FRAs
Terminology
FRA rate
• The FRA rate is the interest rate stipulated in the contract, e.g. here 4½%.
FRA term/Contract period
• The FRA term is the period from settlement date until maturity date. For this
period the interest rate has been fixed. E.g. the term of an 3/9 FRA is 6 months.
• Reference rate
• The reference rate is the rate which the FRA rate is compared to on the fixing
date. The basis for the reference rate is agreed upon on the trade date. Usually
for the main currencies (e.g. USD, GBP, CHF, JPY, AUD, etc.) the LIBOR calculated
by BBA (British Bankers Association) is used. For the EUR it is mostly EURIBOR.
Terminology
• Notional sum: The amount for which the FRA is traded.
• Trade date: The date on which the FRA is dealt.The date on which the
FRA is negotiated between the two counterparties.
• 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.
FRA purchase (buy FRA)
• The buyer of an FRA receives the amount due if on the fixing date the
reference rate is higher than the FRA rate. If the reference rate is
below the FRA rate the buyer has to pay the amount due.
• An FRA can be purchased in order to speculate on rising interest rates
in the future or as a hedge for a future short position in deposits and
thus a protection against rising interest rates.
FRA sale (sell FRA)
• The seller of an FRA receives the amount due if on the fixing date the
reference rate is lower than the FRA rate. If the reference rate is
above the FRA rate the seller has to pay the amount due.
• An FRA can be sold in order to speculate on falling interest rates in the
future or as a hedge for a future long position in deposits and thus a
protection against falling interest rates.
Amount Due
Amount Due
 3/9 or 3x9 FRA means

Amount Due
FRA expires in 3months
We are lending the money based on 6-
month LIBOR (9-3)
So, loan we are giving the individual
matures in 9 months.
If the Amount due is negative, it means
you have to pay, if positive you receive.
3/9 or 3x9 FRA means
*FRA expires in 3months
*We are lending the money based on 6-month LIBOR (9-3)
*So, loan we are giving the individual matures in 9 months.
*If the Amount due is negative, it means you have to pay, if positive you receive.
*Like all other forward contracts, no money is exchanged when entering into a FRA.
*So, taking the long position on a FRA is equivalent to holding a long term Eurodollar time
deposit and at the same time shorting a shorter term Eurodollar time deposit.

Evaluation Date – Underlying

0 g h h+m

Initiation Date. FRA expires.

Example *Used in the FRA markets to determine the

• Consider an FRA expiring in 90 days for which the underlying is 180-day LIBOR.
Suppose the dealer quotes this instrument at a rate of 5.5 percent. Suppose
the end user goes long and the dealer goes short. The end user is essentially
long the rate and will benefit if rates increase. The dealer is essentially short
the rate and will benefit if rates decrease. The contract covers a given notional
principal, which we shall assume is $10 million.
• The contract stipulates that at expiration, the parties identify the rate on new
180-day LIBOR time deposits. This rate is called 180-day LIBOR. It is, thus, the
underlying rate on which the contract is based. Suppose'that at expiration in
90 days, the rate on 180-day LIBOR is 6 percent. That 6 percent interest will be
paid 180 days later. Therefore, the present value of a Eurodollar time deposit
at that point in time would be
Example

At expiration, then, the end user, the party going long the FRA in our example, receives the following
payment from the dealer, which is the party going short:
Example
• If the underlying rate is less than 5.5 percent, the payment is
calculated based on the difference between the 5.5 percent rate and
the underlying rate and is paid by the long to the short. It is important
to note that even though the contract expires in 90 days, the rate is
on a 180- day LIBOR instrument; therefore, the rate calculation
adjusts by the factor 180/360. The fact that 90 days have elapsed at
expiration is not relevant to the calculation of the payoff.
PRICING AND VALUATION OF FRAS
• Previously we used the notations t and T to represent the time to a given
date. The expressions t or T were, respectively, the number of days to time
point t or T, each divided by 360. In the FRA market, contracts are created
with specific day counts. We will use the letter h to refer to the day on which
the FRA expires and the letter g to refer to an arbitrary day prior to
expiration. Consider the time line shown below. We shall initiate an FRA on
day 0. The FRA expires on day h. The rate underlying the FRA is the rate on
an m-day Eurodollar deposit. Thus, there are h days from today until the FRA
expiration and h + m days until the maturity date of the Eurodollar
instrument on which the FRA rate is based. The date indicated by g will
simply be a date during the life of the FRA at which we want to determine a
value for the FRA.
the
te on a
at day 0,
ay h and
ay LIBOR.
f days
ration.
of days in

oan.
ber of days
ation
erm of

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day.
FRA payoff (at expiration) =
NA – Notional Amount
The numerator is the difference between the underlying LIBOR on the expiration day and the rate
agreed on when the contract was initiated, multiplied by the adjustment factor m/360. Both of these
rates are annual rates applied to a Eurodollar deposit of m days; hence, multiplying by m/360 is
necessary. The denominator discounts the payoff by the m-day LIBOR in effect at the time of the
payoff. As noted earlier, this adjustment is necessary because the rates in the numerator apply to
Eurodollar deposits created on day h and paying off m days later. If the notional principal is anything
other than $1, we also must multiply the above payoff by the notional principal to determine the
actual payoff.

To derive the formula for pricing an FRA, a specific arbitrage transaction involving Eurodollars and
FRAs is required. We omit the details of this somewhat complex transaction, but the end result is that
the FRA rate is given by the following formula:
 So to enter into an FRA on day 0, the rate would be 6.1 1 percent. As noted, the initial outlay for
entering the forward contract is zero. Thus, the initial value is zero. Later during the life of the contract,
its value will rise above or fall below zero. Now let us determine the value of an FRA during its life.
Specifically, we use the notation V,(O,h,m) to represent the value of an FRA on day g, prior to
expiration, which was established on day 0, expires on day h, and is based on m-day LIBOR. Omitting
the derivation, the value of the FRA will be
the
ue of
u will
h.

This formula looks complicated, but the ideas behind it are actually quite simple. Recall that we are at
day g. The first term on the right-hand side is the present value of $1 received at day h. The second
term is the present value of 1 plus the FRA rate to be received on day h + m, the maturity date of the
underlying Eurodollar time deposit.

Assume that we go long the FRA, and it is 25 days later. We need to assign a value to the FRA First
note that g = 25, h - g = 90 - 25 = 65, and h+ m - g = 90 + 180 - 25 = 245. In other words, we are 25
days into the contract, 65 days remain until expiration, and 245 days remain until the maturity of the
Eurodollar deposit on which the underlying LIBOR is based. First we need information about the new
term structure.
 NB: We are assuming a $1

Example Notional amount. If the NA is

We now use the formula for the value of the FRA to obtain

Thus, we went long this FRA on day 0. Then 25 days later, the term structure changes to the rates used
here and the FRA has a value of $0.0026 per $1 notional principal. If the notional principal is any
amount other than $1, we multiply the notional principal by $0.0026 to obtain the full market value
of the FRA.

We summarize the FRA formulas in Exhibit 2-8. We have now looked at the pricing and valuation of
equity, fixed-income, and interest rate forward contracts. One of the most widely used types of
forward contracts is the currency forward. The pricing and valuation of currency forwards is
remarkably similar to that of equity forwards.
Summary
ALTERNATIVELY
Original FRA rate at day 0 – 0.0619
 
New FRA rate ast 20 days
FRA(g,h-g,m) =
=0.05968741766
Hence he is losing as he is paying more than what is in the market at 20
days.

 
Value of FRA becomes:
=