A forward rate agreement (FRA) is a cash-settled forward contract on a short-term loan. For example, a 3×9 FRA is a 3-month forward on a 6-month loan—the loan commences in 3 months and matures in 9. The interest rate on the loan—called the FRA rate—is set when the contract is first entered into. Because they are cash settled, no loan is ever extended. Instead, the contracts settle with a single cash payment linked to Libor (or Euribor). As a hedging vehicle, FRA's are similar to Eurodollar futures, but because they trade OTC, they have the advantage that they can be customized for the needs of the counterparties. However, most transactions are fairly standardized. The underlying loan is typically for 3 or 6 months, and quotes are generally available for 1×4, 1×7, 3×6, 3×9, 6×9 and 6×12 deals. Another difference between FRAs and Eurodollar futures is the fact that FRA's entail pre-settlement risk. Eurodollar futures, because they are transacted through an exchange and are margined daily, do not. FRA's settle on the first day of the underlying loan, which is called the settlement date. The formula for the payment is
where
Consider an example. A 4×10 USD 20MM FRA is transacted with an FRA rate of 3.4%. The four month forward period starts on the spot date and extends to the settlement date. Typically, the spot date is two business days after the trade date. Two business days before the settlement date is the fixing date. This is the date on which the value of the reference rate is determined. For this FRA, the reference rate is 6-month USD Libor. Suppose 6-month Libor is 3.7% on the fixing date. The USD money market uses a 360 day basis. On the settlement date, the borrower (the party that is long the FRA) receives from the lender (the party that is short the FRA) the amount
Suppose for this example that there are 186 days in the loan period. In that case, the payment would be USD 30,418.
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