Forward Rate Agreement (FRA):
Forward Rate Agreement (FRA) is an Over The Counter (OTC) interest rate
derivative contract; It is an agreement between two parties to exchange
fixed to floating or vice versa of interest rate commitment on a notional amount
for an agreed period in future. FRA is essentially a forward starting loan but
with no exchange of principal amount. The contract terms determine the notional
principal amount, fixed interest rate (FRA rate), the reference interest rate,
settlement date and maturity date of the notional loan. The principal amount is
only notional and never exchanged but only the interest differential i.e., the
interest calculated on the difference between the initial FRA rate and the
prevailing floating reference rate at the time of settlement is exchanged on the
settlement date.
Key concepts in
FRA:
Notional Amount: Notional Amount of Loan on which interest is calculated
Buyer of FRA: Borrows notional sum of money - The one who longs the FRA -
(typically the one who pays fixed interest)
Seller of FRA:
Lends
the notional sum of money - The one who shorts the FRA -(typically the one who
pays floating interest)
Reference Rate: The floating rate used in the FRA contract (LIBOR, EURIBOR
etc)
FRA Rate - This is the fixed interest rate the buyer of FRA pays or price of the
FRA
Deal Date - Date on which the FRA deal is made
Value Date / Settlement Date - The date on which the forward loan becomes
effective - this in fact is the settlement date on which FRA is cash settled
with exchange of interest differential
Participants in FRA market: Banks / Corporates
Market: Liquid;
quotes are available with banks / dealers across all major currencies
FRA jargon:
Three Sixes (3X6)
FRA - means 3 months loan beginning in 3 months time
One Fours (1X4) FRA - means 3 months loan beginning in 1 month
Three Nines (3X9) FRA - means 6 months loan beginning in 3 months
What happens
after FRA is contracted:
-
If
on settlement date, the prevailing market rate of Reference Rate is greater than
the contract rate, the seller pays the buyer of the FRA the difference;
-
If
on settlement date, the prevailing market rate of Reference Rate is less than
the contract rate, the buyer pays the seller of the FRA the difference;
-
If
Reference Rate is same as the FRA rate on settlement date, there is no exchange
of cash flows
FRA
contract example:
|
Buy or Sell |
Buy
|
|
|
Notional Amount
|
50,000,000
|
The
notional amount for which FRA is contracted
|
|
Trade Date
|
15-Mar-07
|
Date
on which FRA is contracted
|
|
Spot
Date
|
15-Mar-07
|
Usually 0 to 2 days from Trade Date
|
|
Value / Settlement Date
|
15-Jun-07
|
The
date on which the notional loan becomes effective (settlement date); FRA
gets cash settled on this date
|
|
Fixing Date
|
13-Jun-07
|
The
date on which the Reference Rate is determined-
usually 2 days before the Settlement date
|
|
Maturity Date
|
15-Dec-07
|
The
date on which the notional loan matures
|
|
Contract / FRA Rate (%)
|
4.50
|
The
fixed interest rate at which the FRA is
contracted
|
|
Reference Rate
|
3M
LIBOR
|
The
reference rate used for calculation of settlement amount
|
Settlement of
FRA:
As the FRA settlement happens on loan start date (settlement date) i.e., upfront
rather than at the end of the contract period (maturity date), the amount of
interest differential (between contracted FRA rate and prevailing reference rate
on settlement date) is discounted to the settlement date for computing the
actual settlement amount; The settlement amount therefore is calculated using
the following formula:
Settlement Amount= (SettRate-FRARate)*Principal*Days / (Basis*100+Days*SettRate)
where:
SettRate=Settlement Rate (Reference rate prevailing on Rate fixing date)
Basis= Day count basis
(365
or 360)
The above FRA example along with
calculation of the settlement amount is demonstrated in this excel spreadsheet.
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