Forward Rate Agreement

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Forward Rate Agreement</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"><p class="word_list"> <a href="#forward rate agreement">forward rate agreement</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <p class="body">A <b><a name="forward rate agreement">forward rate agreement</a></b> (FRA) is a <a href="../articles/physical%20settlement.htm"> cash-settled</a> <a href="../articles/forward.htm">forward</a> contract on a short-term loan. For example, a 2<img border="0" src="../symbols/multiplication_symbol.gif" align="absbottom" width="7" height="11">5 FRA is a 2-month forward on a 3-month loan. The interest rate on the loan, called the FRA rate, is set when the contract is first entered into. </p> <p class="body">Because FRAs are cash settled, no loan is ever actually extended. Instead, contracts <a href="../articles/settlement.htm">settle</a> with a single cash payment made on the first day of the underlying loan, which is called the <a href="../articles/settlement.htm">settlement date</a>. The formula for the payment is</p> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" height="36" id="table5"> <tr> <td width="100%" align="center"> <img border="0" src="../formulas/forward_rate_agreement_1.gif" width="302" height="45"></td> <td width="5%" align="right">[1]</td> </tr> </table> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table6"> <tr> <td align="right" width="9" height="16"></td> <td width="336" height="16"> <font style="font-size: 16pt">  </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p>where</p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10">notional is the <a href="../articles/notional_amount.htm">notional amount</a> of the loan,<p class="bullet_line_space"> <img border="0" src="../images/bullet.gif" width="20" height="10">the reference rate is typically a <a href="../articles/libor.htm">Libor</a> rate or <a href="../articles/libor.htm">Euribor</a>,<p class="bullet_line_space"> <img border="0" src="../images/bullet.gif" width="20" height="10">days is the number of days the loan is for, and <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10">basis is the day count basis applicable to money market transactions in the currency of the loan—usually either 360 or 365 days.<p class="body">Consider an example. A 4<img border="0" src="../symbols/multiplication_symbol.gif" align="absbottom" width="7" height="11">10 <a href="../articles/currency_codes.htm"> USD</a> 20<a href="../articles/mm.htm">MM</a> FRA is transacted with an FRA rate of 3.4%. The four month forward period starts on the <a href="../articles/settlement.htm">spot</a> date and extends to the <a href="../articles/settlement.htm">settlement</a> 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 <a href="../articles/short_sale.htm">long</a> the FRA) receives from the lender (the party that is short the FRA) the amount</p> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" height="36" id="table7"> <tr> <td width="100%" align="center"> <img border="0" src="../formulas/forward_rate_agreement_2.gif" width="195" height="45"></td> <td width="5%" align="right">[2]</td> </tr> </table> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table8"> <tr> <td width="336" height="10"><font size="2"> </font></td> <td width="9" height="10"></td> </tr> <tr> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="body" style="margin-left: 10; margin-top: 28; margin-bottom: 28">Suppose for this example that there are 186 days in the loan period. In that case, the payment would be USD 30,418.</p> <p class="body" style="margin-left: 10; margin-top: 28; margin-bottom: 28">Although they are traded <a href="../articles/exchange_traded.htm">OTC</a>, FRAs have fairly standardized contract provisions. As a hedging vehicle, they are very similar to Eurodollar <a href="../articles/future.htm">futures</a> but have the advantage that they can be traded for any maturity date. Eurodollar futures, which are traded on exchanges, only mature on four specific dates a year. </p> <p class="body" style="margin-left: 10; margin-top: 28; margin-bottom: 28">Another difference between FRAs and Eurodollar futures is the fact that FRA's entail <a href="../articles/presettlement_risk.htm">pre-settlement risk</a>. 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