Forward Rate Agreement

[Submitted by CA. Vibhuti Gupta,
New Delhi]

June 15, 2009

The forward, or future rate agreement, is a contract between two counterparties to fix a future interest rate. This contract defines the interest rate for a future period based on a principal.

If on the agreed date (fixing date) the FRA-contract-rate differs from the agreed reference rate, a settlement payment depending on the difference must be paid by one of the contractors. The principal is not exchanged and there is no obligation by either party to borrow or lend capital.

Terms used in understanding FRA (Forward Rate Agreement)

1. Forward/Contract rate: The forward rate of interest for the Contract Period as agreed between the parties.
    
2. Interest Settlement Rate : The rate quoted by specified reference banks for the relevant period and currency
    
3. Buyer (Borrower): Party seeking to protect itself against a future rise in interest rate.
    
4. Seller (Lender): Party seeking to protect itself against a future fall in interest rate.
    
5. Settlement Date: The date the contract period commences, being the date on which the Settlement Sum is paid.
    
6. Maturity Date: The date on which the contract period ends.
    
7. Settlement Sum: As calculated by the formula.
    
8. Fixing Date: The day that is two business days prior to the Settlement Date except for pound sterling for which the Fixing Date and Settlement Date are the same.
    
9. Contract Amount: The notional principal on which the Forward Rate Agreement is based.
    
10. Contract Currency: The currency on which the Forward Rate Agreement is based.
     
11. Contract Period : the period from the Settlement Date to the Maturity Date
     
12. Broken Date : Contract Period of a different duration from that used in the fixing of the Interest Settlement Rate and any period exceeding 1 year.
     

Who can use the Forward Rate Agreements?

1. By market participants who wish to hedge against future interest rate risks by setting the future interest rate today (at trading date)
    
2. By market participants who want to make profits based on their expectations of the future development of interest rates
    

FRAs are over the counter (OTC) products and are available for a variety of periods: starting from a few days to terms of several years. In practice, however, the FRA-market for 1-year. FRA offers the highest liquidity and is therefore also regarded as a money-market instrument.

The FRA is not an obligation to borrow or lend any capital in the future. At settlement date, the principal just serves as the basis to calculate the difference between the two interest rates, or rather the settlement payment that result from this difference.

Characteristics of FRAs :

1. An off-balance sheet product as there is no exchange of principal
2. No transaction costs are involved
3. Largest market in US dollars, pound sterling, euro, swiss francs, yen
4. BBA (British Bankers Association) terms and conditions have become the industry standard
5. FRA is a credit instrument (same conditions that would apply in the case of a non-performing loan) although the credit risk is limited to the compensation amount only
6. Transactions done on phone (taped) or telex
7. No initial or variation margins, no central clearing facility
8. Transaction can be closed at any stage by entering into a new and opposing FRA at a new price
9. Can be tailor made to meet precise requirements
10. Available in currencies where there are no financial futures

Quotes:

Prices of Forwards Rate Agreements ( FRAs ) are quoted the same way as money market rates, i.e. as an annualized percentage. FRAs are written as 3-6, 2.8, 4x10, 6vs9 etc. The first figure denotes the Settlement Date, the last figure the Maturity Date, and the difference between the two figures is the Contract Period.

The buyer of the FRA therefore gets the higher rate or the market maker’s offered rate since the buyer is a potential borrower. Likewise, the seller or depositor gets the lower rate or the bid rate.

The functioning of FRAs

1. A customer enters into an agreement with his bank to either buy or sell an FRA.
2. The FRA defines an interest rate for a principal of a deposit or a loan for a defined interest period that will start at a future date. The interest rate on which they agree - also known as FRA rate - is the price of the FRA as it is quoted by the market.
3. By doing so, the bank has not committed itself to lend or take money at this rate. Instead, the customer and the bank agree to compare the fixed FRA rate to a reference interest rate (e.g. LIBOR) two days before the defined interest period (fixing date).
4. The reference rate is defined on fixing date; it is also called settlement rate.
5. Who receives or pays the amount due depends on whether the customer or the bank bought or sold the FRA, and whether the FRA rate is higher or lower than the reference rate at settlement date.
6. If the reference rate is higher than the defined FRA rate, the amount due is paid to the customer.
7. If the reference rate happens to be lower than the FRA rate, the customer must settle the balance.
8. In this process, there is no exchange of principal; only the interest rate gaps are balanced.
9. If on fixing date the FRA rate is higher than the reference rate, the FRA buyer pays to the seller.
10. If the FRA rate is lower than the reference rate, the FRA seller pays the buyer.
11. The payer of the fixed interest rate is also known as the borrower or the buyer, whilst the receiver of the fixed interest rate is the lender or the seller.
12. In principle, the difference between the FRA rate and the reference rate is determined on the basis of the underlying principal on settlement date. The settlement date of an FRA is the first day of the defined interest period. As the FRAs are settled at the beginning of the term,while the accrued interest payments are due only at the end, the settlement payment must be discounted over the interest period.

 
Formula for payment of Settlement Sum : The netted payment made at the effective date is - :

(L-R) or (R-L) x D x A
[(B x 100) + (D x L)]

where: L = Settlement rate (LIBOR)
R = Contract reference rate
D = Days in the contract period
A = Notional principal amount
B = Day basis (360 or 365)

1. The (D x L) factor in the denominator of the BBA formula is the present value of the compensation at the settlement rate.
2. Choose (L-R) or (R-L) so that the difference is positive
3. The FRA interest rate or the Fixed Rate is the rate at which the contract is agreed.( i.e. R as above )
4. The Reference Rate is typically Euribor or LIBOR. The reference rate is defined by the reference banks on the fixing date, and is usually based on LIBOR ( i.e. L as above )
5. The Fixed Rate and Reference Rate are rates that should accrue over a period starting on the effective date, and then paid at the end of the period (termination date).
6. B , i.e., Day Basis is the portion of a year over which the rates are calculated, using the day count convention used in the money markets in the underlying currency. For EUR and USD this is generally the number of days divided by 360, for GBP it is the number of days divided by 365 days
7. The payer of the fixed interest rate is also known as the borrower or the buyer, whilst the receiver of the fixed interest rate is the lender or the seller.

Example: A corporate, with a $10 million floating rate exposure with rollovers to be fixed by reference to the 6-month USD LIBOR rate, expects the short-term interest rates to increase. The next rollover date is due in 2 months. The corporate calls his banker and asks for a 2-8 USD FRA quote (6 month LIBOR 2 months hence). The bank quotes a rate 6.68 and 6.71 (see FRA table below). The customer locks the offered rate 6.71 (borrows at a higher rate).

If the 6-month LIBOR 2 months from now rises by 100 basis points to 7.71 the bank pays the corporate according to the formula - :

 (L-R) or (R-L) x D x A
[(B x 100) + (D x L)]

where: L = Settlement rate (LIBOR)
R = Contract reference rate
D = Days in the contract period
A = Notional principal amount
B = Day basis (360 or 365)

L = 7.71
R = 6.71
D = 6 months ( 180 days )
A = $ 10 million
B = 360 days

Calculations : Therefore the bank would pay the corporate

(7.71 – 6.71) x 181 x $10 million = $48,401.53
[(360 x 100) + (181 x 7.71)]

The compensation amount in the above example is therefore discounted at 7.71 for the six-month period. This reflects the fact that the FRA payment is received at the beginning of the period (settlement date) and the party is therefore in a position to earn interest on it. The 6-month loan payment however is payable at the end of the period.

FRA Table : FRA Descriptive Notation and Interpretation

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