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)

FRAs Notation[edit]

FRA Descriptive Notation and Interpretation

NotationEffective Date from nowTermination Date from nowUnderlying Rate
1 x 41 month4 months4-1 = 3 months LIBOR
1 x 71 month7 months7-1 = 6 months LIBOR
3 x 63 months6 months6-3 = 3 months LIBOR
3 x 93 months9 months9-3 = 6 months LIBOR
6 x 126 months12 months12-6 = 6 months LIBOR
12 x 1812 months18 months18-12 = 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 a "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]

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