Forward Rate Agreements
A forward rate is the interest rate for a future time period. A forward rate agreement (FRA) is a type of forward contract that is based on a specified forward rate and a reference rate, such as the LIBOR, during some future time interval. A FRA is much like a forward-forward, since they both have the economic effect of guaranteeing an interest rate. However, with a forward-forward contract, the guaranteed interest rate is simply applied to the loan or investment to which it applies, while a FRA achieves the same economic effect by paying the difference between the desired rate and the market rate at the beginning of the contract period. FRAs, like other interest rate derivatives, can be used to hedge interest rate risk, profit from speculation, or to profit from arbitrage.
A FRA is a legally binding agreement between 2 parties. Usually 1 of the parties is a bank that specializes in FRAs. As an over-the-counter (OTC) contract, FRAs can be customized to best suit the parties involved. However, unlike exchange traded contracts, such as futures, where the clearinghouse used by the exchange serves as the buyer to seller and the seller to the buyer, there is considerable counterparty risk, where one party may be unable or unwilling to pay the liability if it is due.
Since banks are generally the counterparty to FRAs, the customer will have to have an established credit line with the bank to enter into a forward rate agreement. A credit check will generally require 3 years of annual returns to be considered for an FRA. Contract periods generally range from 2 weeks to 60 months. However, FRAs are more readily available in multiples of 3 months. Competitive rates are available on a notional principal of $5 million or greater, although lower amounts may be offered by a bank for a good customer. Banks like FRAs because they have no capital adequacy requirements.
The parties are classified as buyer and seller. By convention, the buyer of the contract, who wants a fixed interest rate, receives a payment if the reference rate is higher than the FRA rate; if lower, then the seller receives payment from the buyer. The buyer is also sometimes referred to as the borrower and the seller is sometimes referred to as the lender, even though the notional principal is never lent.
The dealing date is when the contract is signed. The fixing date is the date when the reference rate is checked, then compared to the forward rate. For sterling, this is the same day as the settlement date, but for all other currencies, it is 2 business days prior. If the FRA uses LIBOR, then the LIBOR fix is the official quote of the rate for the fixing day. The reference rate is published by the stipulated organization, which is usually promulgated through Reuters or Bloomberg. Most FRAs use the LIBOR for the contract currency for the reference rate on the fixing date.
Unlike most forward contracts, the settlement date is at the beginning of the contract period rather than at the end, since by then, the reference interest rate is already known, so the liability can be fixed. Stipulating that the payment be made sooner rather than later reduces credit risk for both parties. The maturity is the date when the contract period ends. The FRA period is generally designated in reference to the agreement date: number of months till the settlement date × number of months till maturity. Example: 1 x 4 FRA (sometimes, this notation will be used: 1 v 4) designates that there is 1 month between the agreement date and the settlement date and 4 months between the agreement date and the final maturity of the FRA. Hence, this FRA has a contract period of 3 months.
FRAs are cash settled. The payment amount equals the net difference between the interest rate and the reference rate, usually the LIBOR, multiplied by a notional principal, which is not exchanged, but is simply used to calculate the amount of payment. Because the payment recipient receives a payment at the beginning of the contract period, the calculated amount is discounted by the present value, using the forward rate and the contract period.
Common Elements of a Forward Rate Contract
- Notional Principal
- Contract Rate
- the specified fixed interest rate
- Contract Currency
- Dealing Date
- when the FRA is agreed upon
- Settlement Date
- occurs at the beginning of the forward period
- Reference Rate
- the published rate used to determine the market rate, usually the LIBOR for the Contract Currency
- Fixing Date
- date of the Reference Rate that will fix the contract liability
- Maturity Date
- the end of the forward period, when the contract terminates
- Contract Period
- the number of days between the Settlement Date, which is at the beginning of the forward period, and the Maturity Date, which is the end of the forward period
- Settlement Sum
- = (Reference Rate – Contract Rate) × Notional Principal × Contract Period
- if the Settlement Sum is positive, then the FRA seller pays the buyer; otherwise, the buyer pays the seller.
- Payment is made at the beginning of the forward period, discounted by the Contract Period and the Contract Rate
|FRA Payment||=||Settlement Amount||x||Discount Factor|
|=||(Reference Rate – FRA Rate) ×|
Notional Principal ×
1 + Reference Rate ×
Period / Year
|Contract Period (Days)||181|
|Day-Count Convention Year||360|
|$2,488.86||=||(.02 – .015) ×|
181 / 360
Comparing Short-Term Interest Rate (STIR) futures with FRAs
FRAs are similar to short-term interest rate (STIR) futures, but there are some significant differences:
- Futures prices are quoted as an index (= 100 – interest rate), FRAs are quoted as an interest rate;
- so a 2% interest rate would be listed as 2% for a FRA, but as 98 (= 100 – 2) for a STIR future;
- a FRA buyer profits if interest rates rise, while a buyer of the futures contract profits if interest rates fall;
- the FRA settlement is calculated by using the number of days in the forward period, using the actual/360 or actual/365 day-count convention, whereas the future settlement, in the form of variation margin, is calculated using the 30/360 day-count convention;
- the FRA settlement is discounted to the present value of the settlement amount, but the settlement on the futures contract, even though it is settled daily through variation margin, is not discounted;
- other differences result from the fact that the FRA is an OTC contract, whereas futures contracts are standardized and traded on organized exchanges; thus, futures have much greater liquidity and narrower bid/ask spreads.