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FRA Terminology
The fixed rate, also called the FRA rate, is negotiated and agreed upon by both parties before the contract is entered
into. The floating rate, also known as the reference rate, is an interest rate that will fluctuate between when the
contract is agreed upon, and when the loan is set to begin. The two most common floating rates used in FRAs
are LIBOR andEuribor.
FRAs are quoted in the format AxB, with (A) representing the number of months until the loan is set to begin, and (B)
representing the number of months until the loan ends. To find the length of the loan, subtract A from B. For example,
1x4 quote would mean a 3 month loan, set to begin 1 month in the future. Common formats for these quotes include
1x4, 1x7, 3x6, 3x9, 6x9 and 6x12.
Mechanics of a FRA
Consider Company Z on March 1, 2009, which due to unforeseen circumstances must now find $10 million for an
expenditure to occur on June 1, 2009. Company Z expects to generate revenue, and the company expects to be able
to repay this amount on September 1, 2009. Company Z has a number of ways to meet this expenditure; in this
example we only compare a traditional loan to an FRA.
Let's assume Company Z can normally borrow funds for 3 months from its local bank at a rate of 3 month Libor plus
100basis points (bps). If the company takes the first alternative, the effective interest rate it would be able to borrow
at would remain unknown until June 1, when it borrows the actual $10 million at 3 month LIBOR plus 100 bps. Note
that this represents a variable interest rate, as the interest rate in 3 months remain unknown until the actual day
arrives. What if the company wishes to know on March 1, 2009 the interest they must pay on the loan, which will not
occur for another 3 months?
Company Z can also get a quote from a FRA dealer (normally a bank). In this example, the company needs a 3x6
FRA quote (with 3x6 meaning a 3 month loan, to begin in 3 months). Let's assume the FRA dealer offers a quote of
7.0%. This means if the 3 month Libor on June 1 is lower than 7.0%, the FRA dealer will earn the difference between
7.0% and the actual interest rate. Intuitively this makes sense, as the FRA dealer is earning 7.0% on this loan, but it
can borrow at the lower 3 month LIBOR rate. However, if on June 1 the rate is higher than 7.0%, it will lose the
difference.
If Company Z accepts the FRA rate of 7.0% on March 1, then 3 months later (June 1), it will settle in cash this
difference between the previously agreed upon 7.0% and 3 month LIBOR on June 1 2009. If the 3 month LIBOR on
June 1 is lower than 7.0%, the company must pay the FRA dealer. However, if it is higher, the company receives
payment from the FRA dealer. Since the company is effectively borrowing at a lower interest rate than otherwise
possible if the 3 month LIBOR is higher than 7.0%, and as such receives payment. To calculate the amount of the
payment, refer to the formula below.