Forward Rate Agreements

(FRAs)
 Forward Rate Agreement
• A customized contract between two parties that guarantees a certain
interest rate on an investment or a loan for a specified time interval in
the future,

begins on one forward date and ends later

• Forwards have a special notation to designate the future term

For instance, a term that begins in 6 months and ends in 1 year later,
would be designated as 6 v 8
• The interest rate for the shorter period is the market yield with the
term equal to the number of days from the agreement date until the
contract begins

• The longer period is determined using the market yield with the term
equal to the number of days from the agreement date until the
contract ends
 Example
• Two parties can enter into an agreement to borrow 1 million after 60
days for a period of 90 days, at an interest rate of 5%
 Characteristics of FRAs
• Usually cash-settled
• Net amount is settled (difference between the current LIBOR and the
agreed FRA rate)
• Payment made only at maturity
• How a Long Position will benefit?
• How a Short Position will benefit?
• Deposit amount is known as Notional Amount
• Determined on Short-term Interest rates (Reference Rates)
 Mechanism of an FRA agreement
• A bank and a company are agreeing to the company being able to
borrow 50 million for six months in two months’ (2v8) time at 6.543%
interest. Current interest rate is 6%

• Effects, if interest rates move up from 6% to 8% in two months?

• Effects, if interest rates move down from 6% to 5% in two months?
 FRAs Settlements
• The settlement on an FRA is settled net rather than gross.

• The difference is paid or received at the beginning of the forward

period which it related
 Example
• In a 2v5 FRA agreement, the difference is paid after 2 months, that is
the beginning of the forward period.

• If LIBOR is fixed lower than the FRA rate, then the buyer of the FRA would pay
the seller

• If LIBOR is fixed higher than the FRA rate, then the seller of the FRA would pay
the seller
 FRA periods longer than 1 year
• If the period of the FRA is longer than 1 year, the corresponding LIBOR
rates is used for settlement relates to a period where interest is
conventionally paid at the end of each year as well as its maturity.
 Example
• A 6v24 FRA covers a period from 6 months to 24 months and will be
settled against an 18 month LIBOR rate at the beginning of the FRA
period.

• An 18 month deposit would, typically pay interest at the end of one

year and again after 18 months.