FRA

Description:-

A Forward rate Agreement (FRA), is a forward contract in which one party pays a fixed rate of interest, and receives a floating rate equal to a reference rate. The payments are calculated over a notional amount for a certain period, and netted, i.e., only the differential is paid. This is paid on the value date of the trade.

A 2×5 FRA is a 2 month forward on a 3 month loan. The value date on the FRA would be at the end of the second month from the trade date and the maturity date would be at the end of the 5th month from the trade date. The period of the FRA is only for 3 months (5 months – 2 months).

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 . 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.

Example:-

For a basic example, assume Company A enters into an FRA with Company B in which Company A will receive a fixed rate of 5% for one year on a principal of $1 million in three years. In return, Company B will receive the one-year LIBOR rate, determined in three years’ time, on the principal amount. The agreement will be settled in cash in three years.

If, after three years’ time, the LIBOR is at 5.5%, the settlement to the agreement will require that Company A pay Company B. This is because the LIBOR is higher than the fixed rate. Mathematically, $1 million at 5% generates $50,000 of interest for Company A while $1 million at 5.5% generates $55,000 in interest for Company B. Ignoring present values, the net difference between the two amounts is $5,000, which is paid to Company B.

Why are they traded?

Through Forward Rate Agreement a company can lock in an interest rate today, for money the company intends to lend or borrow in the future.

Life cycle events: –

Pay off – is the profit/loss occurred on the trade. In FRA trades the buyer has the obligation to settle the pay off (profit/loss) unlike Option trades where buyer has an option to settle pay off.