3 Forward Rate Agreements and

Interest Rate Swaps

Swaps in all but name have been around for many years. Originally conceived to
help stabilise currencies and facilitate financial activities between governments as
long ago as the 1920s, they have, in recent years, developed beyond recognition
from their forerunners and now play a major global role in corporate sector
financing. Although swaps basically fall into two main categories, interest rate and
currency swaps, within these categories there are many divisions, subcategories,
refinements and derivatives. The market for swaps is global, enormous and highly
liquid; every major financial institution has its swap book which will be passed
from centre to centre as trading closes in one market and opens in another elsewhere
in the world.
This chapter and the next will examine the calculation and uses of interest rate
and currency forwards. In addition Synthetic Agreements for Forward Exchange
(SAFEs), interest rate swaps, the mechanics of their operation, and their advantages
and disadvantages will be examined. These chapters will also consider special types
of swaps, discuss their application, and demonstrate how such instruments operate
in practice and how they might be hedged should the need arise. A more recent
instrument- equity swaps- will be covered in Chapter 5.

3.1 FORWARD INTEREST RATE AGREEMENTS (FRAS)

Having been used for many years in commodity and financial markets as risk
management or hedging instruments, forward contracts have a long, well-established
pedigree. The contracts themselves are very simple. In general they represent an
agreement between two parties (usually two financial institutions or an institution
and a corporate client) to undertake a transaction at some agreed future date at a
price agreed now. The party agreeing to buy at the future date is said to be taking
a long position. The counterparty agreeing to make delivery at the future date is
said to be taking a short position.
The idea of a short interest rate position was illustrated in Figure 2.4 in Chapter
2. The price which appears in the contract is termed the delivery price and delivery
will take place on the settlement day based on a reference rate determined on the
fixing date some days earlier than the settlement date. 1 Benchmarks for short-term,
interbank interest rates are provided by many newspapers as well as specialist data
vendors such as Datastream, Bloomberg, Reuters, etc. The quotes show a bid-offer

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B. A. Eales, Financial Engineering

© Brian Eales 2000
 Forward Rate Agreements and Interest Rate Swaps 79

spread, for example 6!4-6. This spread indicates the rate at which the bank will lend
money (6!4%) and the rate the bank will pay on deposits (6% ). To avoid unnecessary
complication mid-rates will be used in the examples throughout this text.
The idea behind the calculation of forward rates is not complicated. Take the
scenario where an investor has a sum of money to invest for up to a period of 6
months. There are two strategies open to the investor: the principal can either be
deposited with a bank for the full 6 months or it can be invested for a period of 3
months and then reinvested at the end of 3 months, together with the interest which
has accrued, for a second 3-month period. The reinvestment rate at the end of the
third month, which ensures the investor's indifference between the two strategies,
is the forward rate.
It would at this point be useful to compare how the use of short-term interest
rate forwards differs from their exchange-based futures contract counterparts.
Returning to the interest rate example discussed in Chapter 2 will provide a useful
vehicle to achieve this end.

Example 2.1 revisited

Assume that the current interbank offer rate for 3-month money is 6.00%, and that
this is the index on which the company's loan payments are based. Assume further
that the rate for 6-month money is 6.125%. Armed with this information it becomes
possible to calculate an implied 3-month rate that would take effect from the end
of the third month and hold for a further 3-month period.
Calculation of a benchmark for this forward rate can be achieved by using
quoted spot rates on the basis of the following formula:

The 0.5 and 0.25 terms indicate the 3- and 6-month investment horizons and the
rij terms the spot or implied forward interest rates. By inserting the known 3- and
6-month spot rates it becomes clear that the only unknown in the equation is the
r 36 . Rearranging equation (3.1) yields:

r36 -r(1+(6~~~5}(o.s)) 1 I · 4 = 0.061576 (3.1')

(1 +(:~}(o.25))
in other words an implied forward rate of approximately 6.16%.