Forward Rate Agreement


DESCRIPTION

An FRA is very similar to a futures contract. It is an agreement between two parties regarding the value or level of a financial instrument at a future date. Unlike futures, FRAs are not traded on an exchange (This is called OTC, or Over The Counter). Forward Rate Agreements are infinitely more flexible, as they can be structured to mature on any date. In general FRAs are traded on the future level of 3 or 6 month Libor.

The FRA does not involve any transfer of principal. It is settled at maturity in cash, representing the profit or loss resulting from the difference in the agreed rate (FRA rate) and the settlement rate at maturity.

A Forward Rate Agreement (FRA) gives an institution the ability to fix interest rates for periods in the future. A hedge against future values of LIBOR.

Characteristics of FRA's

A FRA is an Off Balance Sheet instrument. Unlike the Cash Deposit market there is no delivery of Capital only the differential between the contract rate and the settlement rate. Any trade entered into does not appear as an asset or liability.


FRA's in use

Bank A has a commitment that requires borrowing Y 10 Billion from the cash market in two months time for a period of three months. It is concerned over the possibility of an interest rate rise within that two month period.

Bank A decides to hedge the risk of an interest rate rise by buying a three month FRA (90 days). It asks the Broker for a price in a 2 X 5 (Two by five). The Broker quotes 8.50-8.45%. Bank A pays the offer at 8.5 % and deals with the counterparty Bank B
The value date is two months from spot date. First fixing is two business days prior to the value date. Maturity will be three months from the value date.

Two months later, on the fixing date, 3m LIBOR is set at 9.00% in line with Bank A's expectations.
When Bank A funds itself in the cash deposit it will have to pay 9.00% . However Bank A bought a FRA at 8.50% and with 3m LIBOR set at 9.00% it realizes 0.50% profit. Bank A will receive the differential between the contract rate and LIBOR setting from Bank B. The real cost of funding is 8.50%.

Two months later, on the fixing date, LIBOR is set at 8.00% against Bank A's expectations.
Bank A funds itself at 8.00%. However it must pay the differential of 0.50% between the LIBOR setting and the contract rate to Bank B. The real cost of funding is 8.50%.
If Bank A is reluctant to commit itself to a specific rate with the obligation to pay or receive funds depending on the LIBOR setting, it may decide to purchase an IRG (Option on a FRA) which confers the right but not the obligation to deal at a specified rate.
Unlike cash deposits where interest is paid on maturity FRA's are discounted by the settlement rate and the differential is paid on the value date.

Calculation formula

((LIBOR-FRA RATE) x FRA DAYS x AMOUNT / (360 x 100 + (LIBOR x FRA DAYS)) = COST
((9.00-8.50)x90x100 Billion)/(360x100+(9.00x90))=12,224,938.87=12,224,939 Profit

This is the profit from buying the FRA. This profit lowers the funding cost to 8.50%.
However if Bank A wished to make a perfect hedge it must include this amount in its cash deposit funding to counterbalance the effect of discounting.

FRA's and Financial Futures; A comparison.

1.TENOR

2.AMOUNT

3.MARKET PARTICIPANTS

4.REPORTING

5.CREDIT RISK

4. Market Conventions

Tenor dates follow the Eurodeposit markets but start dates are flexible..
For example; A 2 X 5 (Fixing 3m interest rate in 2 months time) transacted on 6/01:

 

TENOR

DATE

DETAILS

SPOT

6/03

Two business days after the transaction date

FIXING DATE

8/01

Two days prior to value date. Also known as determination or settlement date.

VALUE DATE

8/03

The start date of the FRA. Funds transferred on this date

MATURITY

11/03

End of FRA. For calculation purposes only.



The diagram shows that the counterparties are trading 3m LIBOR value 3rd August. It is impractical to insist on delivery of funds on the same day as the rate is fixed, particularly if the counterparties are in different timezones, therefore spot value convention of two business days is followed. The Spot value and Maturity convention maintains that Bank and National holidays in the traded currency do not count as business days. This may also include holidays in London and New York depending on the counterparties agreement. However the fixing date is only affected by holidays in London. If theTokyo Market is closed and London is open LIBOR rates are issued and this will be a valid fixing date.

Odd (irregular) start date FRA's are also common. Start dates.in particularly strong demand from Corporates are month , fiscal year and calendar year end.
The Arbitrage opportunities with financial futures create strong demand for odd dates in the OTC market to match the fixed IMM dates.

MAIN INSTRUMENTS

3 MONTH

1x4

2x5

3x6

4x7

5x8

6x9

6 MONTH

1x7

2x8

3x9

4x10

5x11

6x12


LESS ACTIVE

3 MONTH

9x12

12x15

15x18

6 MONTH

9x15

12x18

18x24

1 YEAR

6x18

12x24


OTHERS

0x3

0x6

7x13

11x23 etc..


The convention in the FRA market is that any start date following the spot date and within the same calendar month will be quoted as zero start. A spot start for a 3m FRA would be 0 x 3 "zero-threes over spot" any irregular start will be 0 X 3 over that date. For a start in the next calendar month the FRA will be a 1 x 4 "ones-fours" over the required date and so on 2 X 5 etc.

Eighty percent of the FRA market is comprised of 3m and 6m tenors. Many other tenors ar possible but market demand is limited.For example 1m FRA's are traded but predominantly at the end of the fiscal year.

5. Inter-relationship with Futures (Pricing , Hedge, Arbitrage)

The FRA market participants use Financial Futures to find a theoretical fair value for the FRA, hedge the risk of an interest rate rise or fall and Arbitrage between exchange and OTC prices.

Each institution has its own custom designed method of Risk Management the following is a basic example of risk hedge using futures.

On 20th May Bank A expected interest rates to rise. To counteract this it bought a 3m FRA start date 20th August. the Notional amount was Y10 billion. However Bank A was also concerned over the potential for interest rates to fall so at the same time it purchased futures.

Futures trade as price so as interest rates fall their price will rise. If the FRA and IMM dates match the hedge is easy however in this case the spot start and IMM date do not match so to hedge Bank A must use two futures contracts.

From the diagram it can be seen that June futures cover 1/3 of the FRA and September futures 2/3 of the FRA. There is a Ratio effect between September and June futures of 2:1.
To offset this effect the amount hedged in each futures contract is in the ratio of 2:1. In this case Bank A buys Y3.3 Billion June futures and Y6.7 September futures.
While this is obviously not a perfect hedge the principles involved are the basis for some of the more complicated and exacting hedge techniques. Using sophisticated computer models it is possible to calculate a fair value for any FRA( Strip pricing). Arbitrage opportunities exist when this value is different from the futures actual price.

6. Arbitrage with Eurodeposits

It is frequently possible to Arbitrage with the cash Eurodeposit market. For example; Borrow long term Eurodeposit funds, simultaneously lending short term Eurodeposit funds and selling a delayed start FRA matching the tenor of the long term Eurodeposit. While it is complicated to achieve, opportunities do exist in the market.

The amount invested in the FRA must equal the total of Capital and Interest invested in the short term deposit. In the FRA market it is unlikely that a counterparty will agree to an exact amount it will prefer to deal in round sums of Y1 billion.

EXAMPLE 2

The current 3 v 6 FRA is 6.40%. This means the market is implying that in 3 mths, 3 mth Libor will be 6.40% (A 3 v 9 FRA is trading the implied 6 mth Libor rate in 3 mths time).

Should a corporate believe that 3 mth Libor will be higher than 6.40% in 3 mths, they could enter into an FRA at 6.40% on a prescribed notional where they will profit if Libor is HIGHER than 6.40% and lose if it is LOWER.

FRAs can be used by borrowers to hedge floating rate settings on loans, and by investors to hedge floating rate settings on assets.

PRICING

The FRA rate is the implied forward rate for that date. The value of the FRA will be dependent on the then market view of future rates. The shape of the yield curve is very important in establishing value. See the "Implied Forwards" section for more detail.

TARGET MARKET

FRAs are an attractive instrument for both borrowers and investors who wish to take a view on the future level of short term interest rates. As they are date specific, they are an ideal instrument for hedging future rate settings on loans and financial assets.

ADVANTAGES

DISADVANTAGES

PRODUCT SUITABILITY

Simple Aggressive