Forward Rate Agreements

What are FRAs?

A forward rate agreement (FRA) is an OTC derivative

instrument that trades as part of the money

markets.
It is essentially a forward-starting loan, but with no
exchange of principal, so that only the difference in
interest rates is traded.
By definition, an FRA is an agreement to borrow or
lend a notional cash sum for a period of time lasting
up to twelve months, starting at any point over the
next twelve months, at an agreed rate of interest
(the FRA rate).
The buyer of an FRA is borrowing a notional sum
of money while the seller is lending this cash
sum.

The Buyer of an FRA

So when an FRA is traded, the buyer is borrowing

(and the seller is lending) a specified notional sum

at a fixed rate of interest for a specified period, the
loan to commence at an agreed date in the
future.
The buyer is the notional borrower, and so if there is
a rise in interest rates between the date that the
FRA is traded and the date that the FRA comes into
effect, he will be protected.
If there is a fall in interest rates, the buyer must pay
the difference between the rate at which the FRA
was traded and the actual rate, as a percentage of
the notional sum.

The Seller of an FRA

The counterparty to the transaction, the seller of

the FRA, is the notional lender of funds, and has

fixed the rate for lending funds.
If there is a fall in interest rates the seller will
gain, and if there is a rise in rates the seller will
pay.
Again, the seller may have an actual loan of cash
to hedge or be a speculator.
In FRA trading only the payment that arises as a
result of the difference in interest rates changes
hands. There is no exchange of cash at the time
of the trade.

Typical Example of FRA

Borrowing forward:
Lets assume a person wants to borrow

Rs.100 crore through 4 X 10 forward

against MIBOR
The bank which is willing to sell the FRA
quotes 4 x 10 rate of 4.6% (p.a.)
If after 4 months, 6-month MIBOR is
quoting at 4.8%, the bank refunds 0.2%
If after 4 months 6-month MIBOR is 4.4%,
the person will refund to the bank 0.2%.

HDFC Long dated FRA

Contract

A Company proposes to borrow USD 10

million three months hence for a period of 6

months. The Company arranges for this
facility with a bank today at 1 percent over
the 6 month Libor prevailing on the date of
drawdown of the loan.
Since the reference rate is a floating rate that
would prevail at a future date the company is
not able to determine it's interest cost today.
If the company wishes to get over this
uncertainty, it could buy a FRA (3 v/s 9).

HDFC Long date FRA

Contract

This would essentially be a contract to receive

interest from the FRA seller at a rate at which

the company will eventually be required to
pay on its loan (but without the spread), in
exchange for a fixed rate determined today.
In the example, the buyer of the FRA has

borrowed effectively at a rate at which it

concludes the FRA plus the spread of 1 percent,
since the FRA seller will compensate/be
compensated for the difference in rate between
the FRA rate and the relevant spot Libor rate
determined three months hence.

Settlement of FRA Key

Dates

HDFC Long dated FRA

Contract

Dealing and Quotations:

Deal date or the transactions date, is the date

when the transaction is initiated.

Contract period is the period from the settlement
date to the maturity date.
Settlement date is two days prior to the beginning of
the contract period of the liability or the asset and the
date on which the settlement sum is paid.
Maturity date is date at which the contract ends.
Settlement sum is the amount of money either paid
or received in compensation as per the terms of the
FRA, on the settlement date.
Fixing Date is the date on which the reference rate of
the FRA is decided. This date is generally 2 working
dates before the settlement date, however the same
can be decided mutually by both the counter-parties

Quote of FRA in Mumbai

A quote of 9.75% - 10.25% against 3

month MIBOR for 3 v/s 6 FRA means that

the market maker:
Agrees to pay (bid) 9.75% fixed and
receive the 3 month MIBOR determined
3 months from today.
Agrees to receive (ask/offer) 10.25%
fixed and pay the 3 month MIBOR
determined 3 months from today.

Who can enter FRAs India

In the case of Rupee FRAs banks,

primary dealers and financial institutions

are allowed to enter into FRAs for the
purposes of hedging their exposure as
well as for market making.
Other corporate customers are allowed
to enter into Rupee FRAs ONLY for the
purposes of hedging the interest rate
risk on an underlying asset/liability

Non-Rupee FRA
In the case of non-Rupee FRAs all

participants are allowed to enter into

these transactions only for the purposes
of hedging an underlying exposure :
The purchase of a FRA protects against
a rise in the interest rates, where the
party is to borrow in the cash markets.
The sale of a FRA protects against a fall
in the interest rates, where the party is
to lend in the cash markets.

Settlement of FRA
Consider a case where a corporate has bought Rs.1

million notional of a 1-v-4 FRA, and dealt at 5.75%,

and that the market rate is 6.50% on the fixing date.
The contract period is 90 days.
In the cash market, the extra interest charge that
the corporate would pay is a simple interest
calculation, and is:
(6.50 5.75/(100))*1000000*90/360 = Rs. 1875

This is exactly what the corporate would get as a

seller of the FRA.

In short, interest rates for the corporates are fixed at
5.75% for a period of 90 days. Discount for PV??

Settlement FRA Formula