Forward Rate Agreement

A forward rate agreement (FRA) is a forward contract in which one party, the long, agrees to pay a fixed interest payment at a future date and receive an interest payment at a rate to be determined at expiration. It is a forward contract on an interest rate (not on a bond, or a loan).

FRA "Jargon":

A t1 x t2 FRA: The start date, or delivery date, is t1 months hence. The end of the forward period is t2 months hence. The loan period is t1 - t2 months long. E.g., a 9 x 12 FRA has a contract period beginning nine months hence, ending 12 months hence. The amount used to calculate the interest payments to be exchanged is called the notional principal. The fixed rate is also called the forward contract rate. The interest rate to be determined at expiration is also called the underlying rate. It is typically quoted in LIBOR if the notional principal is a Eurodollar time deposit, and in Euribor if the notional principal is a euro time deposit.

The buyer effectively has agreed to borrow an amount of money in the future at the stated forward (contract) rate. The seller has effectively locked in a lending rate. The buyer of a FRA profits from an increase in interest rates. The seller of a FRA profits from a decline in rates.

If the underlying rate r(t1,t2) exceeds the forward contract rate fr(0,t1,t2) agreed to in the FRA, the FRA buyer profits. The amount paid (at time t1) is the present value of the difference between the underlying rate and the forward contract rate times the notional principal times the fraction of the year of the forward period. A FRA's value is initially zero, when the contract rate is the theoretical forward rate. Subsequently, forward rates will change, so the FRA will have positive value for one party (and equally negative value for the other). A FRA is cash settled. Only the difference in interest rates is paid. The principal is not exchanged.

A FRA is essentially equivalent to a one-period plain vanilla interest rate swap.

The payment of a FRA at expiration is based on the net difference between the underlying rate and the agreed-upon rate, adjusted by the notional principal and the number of days in the instrument on which the underlying rate is based. The payoff is also discounted, however, to reflect the fact that the underlying rate on which the instrument is based assumes that payment will occur at a later date.

Cash settlement payment equals:

Example 1

Shell and Barclays enters into the following FRA:

Shell, the end user, takes a long position in a FRA that expires in 30 days and is based on 60-day LIBOR. Barclays, a dealer, quotes a rate of 5.65% for this FRA. The notional principal of this FRA is $1,000,000.

By convention, this FRA is also referred to as a 1 x 3. At the expiration of the FRA in 30 days:

Shell pays a fixed rate of 5.65% immediately. Barclays promises to pay a rate of 60-day LIBOR determined at expiration. Suppose that the 60-day LIBOR at expiration is 6%. Barclays will pay 6% of interest to Shell 60 days after the contract expiration date. In effect, the 6% interest is paid 90 days (30 + 60) from the contract initiation date.

Example 2

Consider a FRA expiring in 90 days for which the underlying is 180-day LIBOR. Suppose the dealer quotes this instrument at a rate of 5.5%. Suppose the end user goes long and the dealer goes short. The contract covers a given notional principal, which shall be assumed to be $10 million.

The contract stipulates that at expiration, the parties identify the rate on new 180-day LIBOR time deposits. The rate is called 180-day LIBOR. It is, thus, the underlying rate on which the contract is based. Suppose that at expiration in 90 days, the rate on 180-day LIBOR is 6%. That 6% interest will be paid 180 days later. Therefore, the present value of a Eurodollar time deposit at that point in time would be: $10,000,000 / [1 + 0.06 x (180/360)].

At expiration the end user receives the following payment from the dealer: $10,000,000 x {[(0.06 - 0.055) x (180/360)]/[1 + 0.06(180/360)] = $24,272.

It is important to note that even though the contract expires in 90 days, the rate is on a 180-day LIBOR instrument; therefore, the rate calculation adjusts by the factor 180/360. The fact that 90 days have elapsed at expiration is not relevant to the calculation of the payoff.

Most FRAs expire in a given number of exact months, and are based on the most commonly traded interest rates such as 30-day LIBOR, 60day LIBOR, and so on. These standard FRAs are called on-the-run FRAs. For example, a 2 x 4 FRA expires in 2 months, and the underlying rate is 60-day LIBOR. Nonstandard FRAs are called off-the-run FRAs. For example, a FRA that expires in 59 days on 104-day LIBOR.

2. A bank sells a three against nine $3,000,000 FRA for a six-month period beginning three months from today and ending nine months from today. The purpose of the FRA is to cover the interest rate risk caused by the maturity mismatch from having made a three-month Eurodollar loan and having accepted a nine-month Eurodollar deposit. The agreement rate with the buyer is 5.5 percent. There are actually 183 days in the six-month period. Assume that three months from today the settlement rate is 4 7/8 percent. Determine how much the FRA is worth and who pays whom--the buyer pays the seller or the seller pays the buyer. Solution: Since the settlement rate is less than the agreement rate, the buyer pays the seller the absolute value of the FRA. The absolute value of the FRA is:

$3,000,000 x [(.04875-.055) x 183/360]/[1 + (.04875 x 183/360)] = $3,000,000 x [-.003177/(1.024781)] = $9,300.52.

3. Assume the settlement rate in problem 2 is 6 1/8 percent. What is the solution now?

Solution: Since the settlement rate is greater than the agreement rate, the seller pays the buyer the absolute value of the FRA. The absolute value of the FRA is:

$3,000,000 x [(.06125-.055) x 183/360]/[1 + (.06125 x 183/360)] = $3,000,000 x [.006250/(1.031135)] = $18,183.85.

An FRA trader entered into an FRA agreement in which he will pay 6% (assuming quarterly compounding) between 3 months and 6 months. The principal for the trade is $3 million. The 6-month LIBOR spot rate is 5.80%. If trader had a gain of $2550 at the end of the period, the 3month LIBOR rate would be: Choose one answer.

a. 5.30% b. 6.30% c. 5.25% d. 2.51% The correct answer is A

Practice Question 1 A firm sells a 5 x 8 FRA, with a NP of $300MM, and a contract rate of 5.8% (3-mo. forward LIBOR). There are 91 days in the contract period, and a year is defined to be 360 days. On the settlement date, 3 month spot LIBOR is 5.1%. Five months hence, the firm receives ______. Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 2 If the forward contract rate is lower than the underlying rate, A. the FRA borrower pays. B. the FRA lender pays. Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 3 In a forward rate agreement, the buyer agrees to ______. I. Pay a fixed interest rate determined now. II. Pay an interest rate to be determined at a future date. III. Receive a fixed interest rate determined now. IV. Received an interest rate to be determined at a future date. Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 4 True or false? FRAs do not entail the actual lending of money. Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 5

A forward rate agreement is an agreement to buy or sell A. an interest rate contract linked to, say, LIBOR. B. an equity contract. C. a foreign exchange contract. Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 6 In a forward rate agreement, the seller agrees to: I. Pay a fixed interest rate determined now. II. Pay an interest rate to be determined at a future date. III. Receive a fixed interest rate determined now. IV. Received an interest rate to be determined at a future date. A. II and III. B. I and III. C. II and IV. Check AnalystNotes for the correct answer and a detailed explanation.

Practice Question 7 Which of the following combinations of interest rate options would replicate a 6-month by 9-month forward rate agreement to pay 5% fixed? The LIBOR below refers to the 3-month LIBOR. A. Long a 6-month call on LIBOR and short a 6-month put on LIBOR. B. Long a 9-month call on LIBOR and short a 9-month put on LIBOR. C. Long a 6-month call on LIBOR and long a 6-month put on LIBOR.