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Forward rate agreement

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Contents
1 The instruments on which FRAs are based
2 Properties
3 Payoff formula
4 FRAs Notation
5 Valuation
6 Glossary
7 See also
7.1 Associations
7.2 Lists
8 External Links
9 Reference

The instruments on which FRAs are based

Before we understand FRAs, we must examine the instruments on which they are based.

- A large international market exists for time deposits issued by large banks in different currencies.
- The Eurodollar deposit is a dollar deposited outside of the U.S. They are the primary time deposit instrument.
- Banks borrow from each other through Eurodollar time deposits, which are short-term unsecured loans.
- Quoted as an add-on yield rather than on a discount basis.

The London Interbank Offer Rate or LIBOR, is the most common rate for borrowing or lending in the Eurodollar/time
deposit market. This rate is frequently used in derivative contracts. London banks use LIBOR in their transactions with
other banks. LIBOR is typically the rate charged to private, high quality borrowers. Trading in euros/euro deposits occurs
in major global cities - 2 rates are used. EuroLIBOR, and Euribor.

Properties
In Derivatives market, a Forward Rate Agreement (FRA) is a forward contract Between two parties to exchange an
interest rate differential on a notional principal amount at a given future date (Attention NOT expiration) in which one
party, the Long, agrees to Pay a fixed interest payment at a quoted contract rate and Receive a floating interest payment at
a reference rate (Underlying rate), determined at Expiration day (Maturity).

Characteristics of forward rate agreements:

an forward contract of interest rate.

One party makes a fixed interest payment.
The other party makes an interest payment based on a referenced rate at the time of contract expiration.
The underlying is an interest rate.
Payments are based on the difference between the contract rate and the reference rate (e.g., LIBOR).

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A FRA is a cash-settled forward contract on a short-term loan.

The FRA market is not as large as the swaps market.
A swap is a special combination of FRAs.

Payoff formula
The FRA payoff formula is:

Where

Notional Principal of the loan,

The reference rate is typically Libor or Euribor, also refer as floating rate underlying the agreement.
Days is the number of days the loan is for, and
Basis is the day count basis applicable to money market transactions in the currency of the loan either 360 or 365
days.
(Days/360) is the annualized factor based on 360
The numerator is the “interest saving” in percent, and the denominator is the discount factor.

Note that if the floating rate underlying the agreement turns out to be below the forward rate specified in the contract, the
numerator in the formula is negative and the short receives a payment from the long.

FRAs Notation
FRA Descriptive Notation and Interpretation

Notation Contract Expires Settlement Underlying Rate

Expr. x Settlement Starts in A months B months from Now =Settlement – Expr.
1x3 1 month 3 month 3-1, 60-day LIBOR
1x7 1 month 7 7-1, 180-day
3x6 3 months 6 6-3, 90-day
3x9 3 months 9 9-3, 180-day
6 x 12 6 months 12 12-6, 180-day
12 x 18 12 months 18 18-12, 180-day

Valuation

Glossary
LIBOR
Euribor
Compare and contrast Forward Rate Agreement to Interest Rate Option
(http://en.wikipedia.org/wiki/Interest_rate_derivative)

See also
Derivative securities

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Forward contract
Equity forward contract
Bond forward contract
Currency forward contract
Swap
Forward starting swap
option
interest rate swap
financial future

Associations

International Swaps & Derivatives Association - http://www.isda.org/

Lists

List of finance topics

External Links
Investopedia (http://www.investopedia.com) - Investor Education
Terminology & FAQ from ISDA (https://www.isdadocs.org/conf/index.html)
ISDA presentations on risk management and capital issues (https://www.isdadocs.org/conf/index.html)
What do I read to learn about derivatives?
(http://www.bus.lsu.edu/academics/finance/faculty/dchance/Research/ReadingList.htm)
Don Chance's List of Derivatives Sites on the Web
(http://www.bus.lsu.edu/academics/finance/faculty/dchance/Research/DerivativesSites.htm)

Reference
Don M Chance, Ph.D., CFA "Analysis of Derivatives for the CFA Program," CFA Institute, pp.34-36

Chance, Don M. Analysis of Derivatives for the CFA Program. Charlottesville: Association for Investment
Management and Research (2003). This book prepares CFA candidates for taking the exam. Treatment of
derivatives is focused strictly on what you need to know to pass the exam. Don't buy it to learn derivatives, because
it's not oriented toward a derivatives specialist. But do buy it if you have to pass the CFA exam.

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This page was last modified 17:40, 23 August 2005.

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