Forward rate agreement

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In finance, a forward rate agreement (FRA) is a forward contract, an over-the-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.[1] 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. FRAs are very similar to swaps except that in a FRA a payment is only made once at maturity. Instruments such as interest rate swap could be viewed as a chain of FRAs.

Many banks and large corporations will use FRAs to hedge future interest or exchange 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.[citation needed] The development swaps in the 1980s provided organisations with an alternative to FRAs for hedging and speculating.

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.

Payoff formula[edit]

The netted payment made at the effective date is as follows


\mbox{Payment} = \mbox{Notional Amount} * \left( \frac{(\mbox{Reference Rate}-\mbox{Fixed Rate}) * \alpha }{ 1 + \mbox{Reference Rate} * \alpha } \right)

  • The Fixed Rate is the rate at which the contract is agreed.
  • The Reference Rate is typically Euribor or LIBOR.
  • \alpha 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[edit]

FRA Descriptive Notation and Interpretation

Notation Effective Date from now Termination Date from now Underlying Rate
1 x 4 1 month 4 months 4-1 = 3 months LIBOR
1 x 7 1 month 7 months 7-1 = 6 months LIBOR
3 x 6 3 months 6 months 6-3 = 3 months LIBOR
3 x 9 3 months 9 months 9-3 = 6 months LIBOR
6 x 12 6 months 12 months 12-6 = 6 months LIBOR
12 x 18 12 months 18 months 18-12 = 6 months LIBOR

How to interpret a quote for FRA?

[US$ 3x9 - 3.25/3.50%p.a ] - means deposit interest starting 3 months from now for 6 month is 3.25% and borrowing interest rate starting 3 months from now for 6 month is 3.50% (see also bid–offer spread). Entering an "payer FRA" means paying the fixed rate (3.50% p.a.) and receiving a floating 6-month rate, while entering a "receiver FRA" means paying the same floating rate and receiving a fixed rate (3.25% p.a.).

References[edit]

See also[edit]