Forward Rate Agreement (FRA)

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Presented By: Arvind rathi Sumit sharma Shoubhik Dasgupta

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Flow of the Presentation

FRA Terminologies used Illustration Calculations

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Forward Rate Agreements (FRA)

While futures and forward contracts are

similar, forward contracts differ because

they are negotiated between counter-parties, is no daily settlement or marking-tomarket, exchange guarantees performance are cash-settled at the settlement date with no interim cash flows.
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there no

FRAs

Notional Principal Amounts

The two counterparties to an FRA agree to a notional

principal amount that serves as a reference figure in determining cash flows.

notional refers to the condition that the principal does not change hands, but is only used to calculate the value of interest payments. The buyer of the FRA agrees to pay a fixed-rate coupon payment and receive a floating-rate payment against the notional principal at some specified future date. The seller of the FRA agrees to pay a floating-rate payment and receive the fixed-rate payment against the same notional principal.

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A forward rate agreement (FRA) is a forward contract based on interest rates

The buyer of an FRA agrees to pay a fixed-rate coupon

payment (at the exercise/contract rate) and receive a floating-rate payment against a notional principal amount at a specified future date.

The buyer of an FRA will receive (pay) cash when the actual interest rate at settlement is greater (less) than the exercise/contract rate (specified fixed-rate).

The seller of an FRA agrees to make a floating-rate payment

and receive a fixed-rate payment against a notional principal amount at a specified future date.

The seller of an FRA will receive (pay) cash when the actual interest rate at settlement is less (greater) than the exercise rate.
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deferment period
dealing date spot date fixin g date reference rate determine d

contract period
settlemen t date settlemen t sum paid maturit y date

contrac t rate agreed

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 On the dealing date, two parties to the FRA agree on all the terms.

E.g. dealing date = Monday 12th April 1993 two parties agree to trade 1x4 FRA in $1M at 6.25% Meaning: contract currency = US dollar contract amount = $1 million contract rate = 6.25% 1x4 one-month period between the spot date and the settlement date

four-month period between the spot date and final maturity of the notional loan

the

Spot date is normally two business days after the dealing date, so it is

Wednesday 14th April 1993.

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 Settlement date is 14th May, 1993.

Maturity date is 16th August, 1993.

Contract period is 94 days.

The fixing date is when the reference rate is determined and it is two

days before the settlement date.

The reference rate is the rate on which the two parties agree to take as a

basis for settlement.

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Forward Rate Agreements: An Example

Seller: Metro Bank will receive fixed rate payments

at 7% and will make floating-rate payments at 3month LIBOR.

Buyer: County Bank will receive floating-rate

payments at 3-month LIBOR and will make fixed rate payments at 7%.

Notional principal = $1,000,000 Maturity = 6 months

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 Metro Bank would refer to this as a 3 vs. 6 or 3x6 FRA at

7 percent on a $1 million notional amount from County Bank.

a 6-month maturity based on a $1 million notional principal amount floating rate is 3-month LIBOR and the fixed (exercise) rate is 7 percent

The phrase 3 vs. 6 refers to a 3-month interest rate

observed three months from the present, for a security with a maturity date six months from the present.
So, the settlement is 3 months from today and the maturity is

6 months from today.

The only cash flow will be determined in six months at

contract maturity by comparing the prevailing 3-month LIBOR with 7 percent. 5/4/12

 Assume that in three months, the 3-month LIBOR equals 8

percent. $2,451.

In this case, County Bank would receive from Metro Bank

But How ???

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 The interest settlement amount is $2,500:

interest = (0.08 - 0.07)(90/360)($1,000,000) = $2,500.

Since this amount represents interest that would be paid

three months later at the maturity of the instrument, the actual payment is discounted at the prevailing 3-month LIBOR:

actual interest paid = $2,500/[1+(90/360)(0.08)]=$2,451

If instead, LIBOR equals 5 percent in three months, County

Bank would pay Metro Bank:

interest = (0.07 -0.05)(90/360)($1,000,000) = $5,000 $5,000 / [1 + (90/360)(0.05)] = $4,938

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3 months deferment period

dealing date spot date fixin g date reference rate determine d 8%

3 months contract period

settlemen t date settlement sum paid $2,451 Metro Bank pays since 8% > 7% maturit y date

contract rate agreed 7% vs 3-mo LIBOR

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3 months deferment period

dealing date spot date fixin g date reference rate determine d 5%

3 months contract period

settlemen t date settlement sum paid $4,938 County Bank pays since 5% < 7% maturit y date

contract rate agreed 7% vs 3-mo LIBOR

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Metro and County Banks positions are similar to a futures position

In the previous example, County Bank would pay fixed-rate

and receive floating-rate as a hedge if it was exposed to a loss in a rising rate environment.

This is analogous to a short futures position since

with short futures, rising rates means falling prices falling prices mean selling for higher at the beginning and buying for cheaper at the end

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Metro Bank would pay floating-rate and receive fixed-

rate as a hedge if it was exposed to a loss in a falling rate environment.

This is analogous to a long futures position since

with long futures, falling rates means rising prices rising prices means buying for cheaper at the beginning and selling for higher at the end

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Thank You

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