Forward Rate Agreement

Topics

1. Brief Review: Fixed Income Securities

2. Yield Curve and Term Structure
3. Forward Rate Agreement

Dr. Melanie Cao, SSB, FINE6800 1

1. Brief Review of Fixed Income Securities:

A. Money Market Instruments:

short-term marketable securities

A.1 Treasure bills (T-bills):

 Maturity: 3, 6, 12 months
 Issued weekly through auctions by competitive bidding
 Participants: banks and authorized dealers
 Face value (FV): $1,000, $5,000, $25,000, $100,000 and
$1,000,000

Dr. Melanie Cao, SSB, FINE6800 2

 A. Money Market Instruments:
short-term marketable securities …continued

A.2 Commercial Paper

 Issued by large, well-known companies;

 They are unsecured;
 Backed by a bank line of credit;
 Yield: slightly higher than the corresponding T-bill since
corporations are riskier than governments.

Dr. Melanie Cao, SSB, FINE6800 3

 A. Money Market Instruments:
short-term marketable securities …continued

A.3 Certificates of Deposits & Deposit Notes

 Certificate of Deposit (CD): time deposit with a bank

 Guaranteed Investment Certificates (GIC)

A.4 Bankers’ Acceptances:

 Similar to post dated checks which are guaranteed by banks

Dr. Melanie Cao, SSB, FINE6800 4

 A. Money Market Instruments:
short-term marketable securities …continued

A.5 Eurodollar:

 U.S. dollar denominated deposit at foreign banks

 Euro currency: XXX currency denominated deposit outside
of the XXX currency jurisdiction.
 Euro currency is not the same as Euro (the common currency
for the European Monetary Union adopted on Jan.1, 1999).

Dr. Melanie Cao, SSB, FINE6800 5

 A. Money Market Instruments:
short-term marketable securities …continued

A.6 Repos (Repurchase Agreements):

 A form of overnight borrowing;

 Selling one’s asset at a price today and repurchasing it back
tomorrow at a higher price;
 Term repo: maturity to 30 days.

Dr. Melanie Cao, SSB, FINE6800 6

 A. Money Market Instruments:
short-term marketable securities …continued

A.7 LIBOR market:

 London InterBank Offering Rate (LIBOR)

 LIBOR rates are the benchmark for many derivatives, such as
swaps, the CME’s Eurodollar contract (the largest short-term
futures contracts).

Dr. Melanie Cao, SSB, FINE6800 7

 B. Longer Term Fixed-Income Capital Market:

B.1 Treasure bonds (T-bonds):

 Canada Savings Bonds (CSB): non-marketable, issued on

Nov. 1 each year with a 7-year maturity
 Canada Bonds: marketable with maturity up to 40 years

Dr. Melanie Cao, SSB, FINE6800 8

 B. Longer Term Fixed-Income Capital Market:
…continued

B.2 Local Government bonds:

 Similar to T-bonds;
 However, the yield is slightly higher than that of the
corresponding T-bond since local government is riskier than
the Federal government.

Dr. Melanie Cao, SSB, FINE6800 9

 B. Longer Term Fixed-Income Capital Market:
…continued
B.3 Corporate Bonds:

 Higher default risk;

 Secured bonds are backed by the company’s assets in the event of
bankruptcy;
 Unsecured bonds (or debentures) have lower priority claim than the
secured bonds in the event of bankruptcy;
 Subordinated debentures: lower priority claim than debentures;
 Callable bonds give firm the right to repurchase the outstanding
bonds;
 Convertible bonds give the holders the right to convert bonds into
equity

Dr. Melanie Cao, SSB, FINE6800 10

 2. Yield Curve and Term Structure

A. Term Structure (TS)

• Also called "yield curve" or "pure yield curve". It depicts

relationship between time-to-maturity and Yield-To-Maturity
(YTM) for zero-coupon (or discount) bonds.

• YTM is also referred as zero rate.

Dr. Melanie Cao, SSB, FINE6800 11

 Illustration

Maturity YTM
(years)
1 0.1

2 0.105 What determines the shape?

3 0.11

4 0.12

5 0.13

6 0.135

Dr. Melanie Cao, SSB, FINE6800 12

 B. Three Interest Rate Theories

B.1 Expectations Theory (Hypothesis)

• Shape of TS is explained by market participants' expectations

of interest rates. Specifically, long term rate is Geometric
mean of future short rates.

Dr. Melanie Cao, SSB, FINE6800 13

 Example 3.1

Calculate the yields to maturity of each bond

Maturity (years) Zero-coupon Bond Price

1 943.40

2 898.47

3 847.62

4 792.16

Dr. Melanie Cao, SSB, FINE6800 14

Forward Rates: Implied Future Spot Rates

Dr. Melanie Cao, SSB, FINE6800 15

 Example 3.1
…continued

What are the implied forward rates?

Maturity (years) 1 2 3 4

Price of Bonds 943.40 898.47 847.62 792.16

YTM 5.83% 5.35% 5.51% 5.82%

Dr. Melanie Cao, SSB, FINE6800 16

B.2 Liquidity Preference Theory (Hypothesis)

• Long-term returns should be higher to compensate for

inflexibility and uncertainty.

 An improvement over exp. Theory which assumes perfect

forecasts;
 Also an extension of exp. Theory.

Dr. Melanie Cao, SSB, FINE6800 17

 Illustration

Dr. Melanie Cao, SSB, FINE6800 18

 B.3 Market Segmentation Theory (Hypothesis)

• Also known as institutional theory and hedging pressure

theory.

 Demand/supple of funds are distinct in different maturity

segments. That is, short term: money market; medium:
mortgages; long term: life insurance;
 Shape of term structure depends on demand/supply in each
market.

Dr. Melanie Cao, SSB, FINE6800 19

C. Term Structure Estimation: Bootstrap Method

Example 3.2

Annual Coupon Maturity (years) Bond Price

0 1 909.09

5% 2 905.39

12% 3 1026.30

7% 4 851.96

Dr. Melanie Cao, SSB, FINE6800 20

 3. Forward Rate Agreement (FRA)

A. FRA is a forward contract on an interest rate for a specific

future period traded through the Over-The-Counter (OTC)
market. It is similar to the Euro-dollar futures contracts traded
at the CME (Hull, Chapter 6.4, page 137).

Dr. Melanie Cao, SSB, FINE6800 21

 Example:

• Two parties agree that the one-year rate 6 months from now will be
5.5%. After 6-months, depending on the actual one-year rate, one party
will pay the other.

Dr. Melanie Cao, SSB, FINE6800 22

 B. FRA’s are settled in cash

• At initiation, to make the forward contract worth zero, the agreed

forward rate should be the forward rate.

• Suppose principal is $1,000 and contract is for T* - T at the agreed rate

RK. For the short party,

Time T: -$1,000 Time T*: 1,000 e RK(T* - T)

PV of the contract = $1,000e RK(T* - T) e -r * T* - 1,000e -rT

Set it to zero and solve for RK,

Dr. Melanie Cao, SSB, FINE6800 23

 B. FRA’s are settled in cash

…continued

• At any time after initiation, the contract value for a short

position:

Dr. Melanie Cao, SSB, FINE6800 24

 Example:

A 2-year period FRA (T*-T = 2 years) with principal $1,000,000;

Contract rate is RK = 10%; 6 months left to maturity (T-t = 6 months);

Current 6- and 30-month rates are r (t,T) = 9.5% and r* (t, T*) = 10.5%.

Dr. Melanie Cao, SSB, FINE6800 25

 Example: …continued

Then:

lost money, because the current implied forward rate is:

which is higher than the contracted rate of 0.10.

Dr. Melanie Cao, SSB, FINE6800 26

 Example: …continued

6 months have passed. The FRA is at maturity. The actual 2-year

rate is 10.5%, then the cash settlement is:

Dr. Melanie Cao, SSB, FINE6800 27