Forward Rate Agreement

Explained: forward rate agreement

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

[1]

where

notional is the notional amount of the loan,

the reference rate is typically a Libor rate or Euribor,

days is the number of days the loan is for, calculated using the actual number of days in each month, and

basis is the day count basis applicable to money market transactions in the currency of the loan—360 days for USD or EUR; 365 days for GBP.

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

[2]

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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bankers acceptance An acceptance that has a bank as its drawee. compound interest Any of several methods of crediting interest in which interest is earned on interest. convexity bias A bias in Eurodollar futures rates that makes them slightly higher than corresponding forward rates. credit risk Risk due to uncertainty in a counterparty's ability to meet its obligations. derivative instrument An instrument which derives value from the value of some commodity, energy, or other financial instrument. Eurodollar deposit A deposit of US dollars held at a bank branch outside the United States. Eurodollar future A cash-settled future on a 3-month Eurodollar deposit. fixed income term structure Refers collectively to a spot curve, forward curve, discount curve, yield curve or any other curve that describes the time value of money at a particulate point in time. floater A fixed income instrument whose coupon fluctuates with some designated reference rate. forward contract A trade that is agreed to at one point in time but will take place at some later time. future An exchange-traded derivative that is similar to a forward. interest rate parity An arbitrage condition that must hold between the spot interest rates of different currencies. interest rate swap A swap under which both cash flow streams are in the same currency and are defined as cash flow streams that might be associated with some fixed income obligations. Libor London Interbank Offered Rate.
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