OTC Derivatives - Forward Rate Agreements Lecture-

Session 6

What are FRAs?

 Forward rate agreements (FRAs) are contracts for

difference.
 They are traded in the over-the-counter (OTC
bilateral or non-exchange) market.
 They allow the two parties involved to hedge or
speculate on interest rates in the future.

The easiest way to understand a FRA is to break it

down into a loan and deposit.

 Suppose you borrow $10,000,000 for 182 days at a

rate of 4% and then you lend the $10,000,000 for
91-days at 3%.

 In 91-days time your 3% loan will mature. You now

have a further 91 days to re-lend the money. What
interest rate must you obtain on this second loan
in order to have enough capital to repay your
original 6 month borrowing?
Your six-month borrowing:
Amount: $10,000,000.00
Rate: 4%
Days: 182
Interest: $202,222.22
Repayment: $10,202,222.22

Your three-month loan:

Amount: $10,000,000.00
Rate: 3%
Days: 91
Interest: $75,833.33
Repayment: $10,075,833.33

The interest amount you must earn for the second 91-
day period is ($10,202,222.22 -$10,075,833.33)
= $126,388.89

How much capital is at your disposal? $10,075,833.33

So the rate you need to earn is: 126,388.89 /

10,075,833.33 x 360 / 91 = 4.96% (Act/360 or MM
Basis)

In other words, the forward rate is 4.96%

When the short rate is lower than the long rate (a
positive sloping yield curve) the forward rate is
higher than spot interest rate. For a negative sloping
yield curve the forward rate is lower than the spot
rate.

But in reality forward loans are not traded!

Banks don’t lend and borrow cash when trading

forward rates, (too much credit and capital would be
required). They just enter a deals based on the forward
rates themselves called FRAs.

How a FRA works!!

A dealer quotes a 3 x 6s FRA at 4.94 - 4.98 (3 x 6 refers

to a three-month rate starting in three-months time)

A customer wishing to protect against rising interest

rates enters into the FRA with the dealer at
4.98%. (Note the customer is getting the worst rate
because the dealer dictates the terms of the trade.)

The Notional Principal concept

The trade ticket is processed and the bank and

customer confirm the deal. There is no exchange of
principal at this point and the quote is based on a
“notional” principal amount of $ 10,000,000.00

We now wait three months in order to see where three

month Libor “fixes”. It could be higher, the same
as or lower than the rate on the trade (4.98%).

Let’s see what happens in each case.

Rate Fixing FRA Customer gain/loss

5.08% 4.98% +0.10%
4.98% 4.98% 0.00%
4.88% 4.98% -0.10%

When 3 month Libor fixes above 4.98% the customer

gains and the dealer loses, when Libor fixes
below 4.98% the customer loses and the dealer gains.

So just how could the FRA be of use?

 For this customer an FRA can hedge against rising

Libor rates. The sort of risk associated with
variable rate loans.
 Money market and ALM dealers also use FRAs.
They help them lock-in forward
borrowing and lending rates and interest
payments associated with Libor re-fixings (rolls).
 An additional attraction is that FRAs are bilateral
OTC trades and, therefore, specific forward
 periods can be matched precisely.

Discounted settlement

One unusual feature of FRAs is their settlement. FRAs

settle “up-front” that is on the date of the Libor
fixing. This means the payment is discount.

Let’s see this.

Take the case where Libor fixes at 5.08%. The customer
profits by 0.10%. On a $10,000,000 trade that
is:
$10,000,000 x 0.10% x 91 / 360 = $2,527.77

This sum is discounted at the Libor rate of 5.08%:

$2,527.77 / (1 + 0.0508 x 91 / 360) = $2,495.72 (the
sum received by the customer)
Is there anything else?

Yes! You can calculate forward interest rates for any

period in the future. That’s a useful piece of
Information since it gives you an unbiased view of
where interest rates will be in the future. It’s not only
useful for traders it’s also helpful to anyone involved in
the planning process.

One last point

Over-the-counter trades incur credit risk on the
counterparty (the mark-to-market value and any
potential future exposure). FRAs are no exception.
Before dealing a credit assessment of the
counterparty and a dealing limit are mandatory.