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Dec 07, 2010, 02.09 PM IST | Source: Moneycontrol.com

Forward Rate Agreement: Mecklai Finanial

This article has been sourced from Mecklai. You can visit their website www.mecklai.com for futher information. Forward Rate Agreement.

Forward Rate Agreement: Mecklai Finanial

This article has been sourced from Mecklai. You can visit their website www.mecklai.com for futher information. Forward Rate Agreement.

 

Basics: A Forward Rate Agreement (FRA) is an agreement between two parties that determines the forward interest rate that will apply to an agreed notional principal (loan or deposit amount) for a specified period.

 

FRAs are basically OTC equivalents of exchange traded short date interest rate futures, customized to meet specific requirements.

 

FRAs are used more frequently by banks, for applications such as hedging their interest rate exposures, which arise from mis-matches in their money market books. FRA’s are also used widely for speculative activities.

 

Characteristics of FRAs

 

Achieves the same purpose as a forward-to-forward agreement

 

An off-balance sheet product as there is no exchange of principal

 

No transaction costs

 

Basically allows forward fixing of interest rates on money market transactions

 

Largest market in US dollars, pound sterling, euro, swiss francs, yen

 

BBA (British Bankers Association) terms and conditions have become the industry standard

 

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

 

Transactions done on phone (taped) or telex

 

No initial or variation margins, no central clearing facility

 

Transaction can be closed at any stage by entering into a new and opposing FRA at a new price

 

Can be tailor made to meet precise requirements

 

Available in currencies where there are no financial futures.

 

An 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).

 

Calculations

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 BBA 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)

 

Note: Choose (L-R) or (R-L) so that the difference is positive

 

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)]

 

If interest rates had fallen by 100 basis points the corporate would have to compensate the bank by an equivalent amount.

 

The result from this formula can also be obtained intuitively as follows:

 

The interest gain from entering the FRA is calculated as
1% x $10million x 181/360 = $50,277.78

 

The present value of $50,277.78 for a 6-month period discounted by the Settlement Rate (LIBOR) is:


$50,277.78 / {1+[7.71% x 181/360]} = $48,401.53

 

The (D x L) factor in the denominator of the BBA formula is the present value of the compensation at the settlement rate. 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.

 

British Bankers’ Association’s recommended terms
The BBA set up standards for FRA agreements, known as BBAFRA terms, to provide recommended terms and conditions for FRA contracts to provide guidance on market practice. Banks not dealing on BBA terms have to make it clear to the counterparty that the FRA is not governed by these terms.


FRA Terminology

 

FRA

FRA Forward Rate Agreement

Forward/Contract rate

the forward rate of interest for the Contract Period as agreed between the parties.

BBA Designated Banks

means the panel of not less than 12 banks designated from time to time by the BBA for the purpose of establishing the BBA Interest Settlement Rate.

BBA Interest Settlement Rate

The rate quoted by specified reference banks for the relevant period and currency.Most currencies LIBOR can be taken as shown on LIBO or LIBOR01 on Reuters or page 3750 on Telerate. For AUD the corresponding Reuter page is BBSW.

Buyer (Borrower)

Party seeking to protect itself against a future rise in interest rate.

Seller (Lender)

Party seeking to protect itself against a future fall in interest rate.

Settlement Date

the date the contract period commences, being the date on which the Settlement Sum is paid.

Maturity Date

the date on which the contract period ends.

Settlement Sum

as calculated by the BBA formula.

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.

Contract Amount

the notional principal on which the FRA is based.

Contract Currency

the currency on which the FRA is based.

Contract Period

the period from the Settlement Date to the Maturity Date.

Broken Date

Contract Period of a different duration from that used in the fixing of the BBA Interest Settlement Rate and any period exceeding 1 year

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Quotes


Prices of 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.

FRAs are sometimes quoted as "offer-bid" rates, the same method of quoting followed by money market rates. 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 main Contract Periods traded are 3 months and 6 months although 12-month periods are gaining popularity. Broken date prices are also available though the spreads maybe wider and may take longer to obtain. Contract periods less than 3 months are difficult to obtain due to the nature of FRA trading (slim profit margins make it uneconomical).

Value dates for FRAs follow the dates applicable to money markets (called "straight dates"). Trading lots are usually good for 5 million units of the currency (yen excepted).

Settlement

 

The compensating amount reflects the difference between the actual / Settlement Rate for the period and the Contract Rate. The Settlement Rate, according to the BBA definition, is the rate calculated by taking the rates quoted by eight BBA Designated Banks as being in their view the offered rate at which deposits in the Contract Currency for such Contract Period are being quoted to prime banks in the London interbank market at 11.00 a.m. on the relevant Fixing Date for Settlement Date value. The two highest and the two lowest rates are eliminated and the remaining of the four rates are averaged and then rounded upwards to five decimal places.

In the event that the Settlement Rate is higher than the Contract Rate the borrower would receive payment from the seller. Conversely, the depositor would receive the compensating amount if the interest rates fall. Settlement of the compensating amount takes place at the beginning of the FRA. The first date of the Contract Period is defined as the Settlement Date. Euro FRAs rates are fixed two days ahead of the Settlement Date.

As the payment is an upfront payment the Compensating Amount is a discounted amount. The actual/discount rate used to calculate the Compensating Amount is taken as LIBOR or the offer rate of the money market quote. For market makers (usually banks) who expect to deposit at the offer rate and buyers of FRAs this method of discounting is not a problem. Sellers of the FRA will be disadvantaged if they place their deposits on the bid side of the quote and therefore will not be hedged at the Contract Rate. Their effective hedge will be lower by the spread between the quotes (usually 1/8%).

Applications
Hedging future interest rate exposure is the predominant use of a FRA. Banks hedge their money market mis-matches and corporates for future borrowings/deposits. Arbitrage between FRAs and short-term interest rate futures provide a good opportunity to banks. These short-term futures contracts provide a good source of hedging for FRA market makers.

Arbitrage between FRAs and forward-forward rates in the cash markets may be theoretically possible but rarely seen in practice. Speculation in FRAs is attractive, as there are no transaction fees involved. This type of activity is usually confined to banks.

Conclusion

 

There are many variations to the traditional FRAs and are gaining popularity. These include -

 

"Strip" FRAs or a combination of FRAs to lock a series of interest rates reset periods.

 

A synthetic FRA in a foreign currency by combining FRAs in one currency and FX Forwards in the other

 

Forward Spread Agreements (FSAs) are essentially used to lock the interest rate differentials between two currencies. This type of transaction is entered between two parties who wish to hedge themselves against future changes in the LIBOR for two currencies one of which being the USD.



FRAs can be priced off forward to forward interest rates. These forward to forward rates can be obtained from the cash market yield curve or by the implied forward rates available from the interest rate futures market in the relevant currency.

Banks have recently started to quote FRA prices in the Indian currency. Forward rates can be constructed from securities of different maturities. FRAs in rupee can be synthetically created using the USD FRA in conjunction with rupee forwards in the foreign exchange markets or rupee interest rate swaps against MIBOR. However, forward rates in the foreign exchange markets are liquid upto 12 months only.

For example, suppose an Indian corporate is to issue a 6-month commercial paper. The current 3-month CP rates are 10.80 and the 6-month rates are 11.50. The corporate is of the view that the 6-month rates are high and is of the view that the rates should fall in the near term. The corporate could then sell a 3x6 FRA. If the rates do fall the corporate would receive the compensating amount from his bank therefore reducing his borrowing cost. Alternatively the corporate could issue a 3-month CP at 10.80%, lock in the 3x6 FRA rate, and issue another 3-month CP after 3 months (this strategy assumes the CP issuance costs involved are negligible). The Indian bank in turn could hedge his exposure in the forward markets by paying (borrowing) 6-month forward and receiving (lending) 3-month forward. Typical trading lot size would be 10 crores although 5 crores may be acceptable.

FRA quotes from Reuters TOPFRA page

 

USD

EUR

JPY

1x4

6.73

6.76

5.1650

5.1950

0.53

0.57

2x5

6.69

6.72

5.13

5.15

0.47

0.51

3x6

6.63

6.66

5.12

5.15

0.46

0.50

4x7

6.65

6.68

5.14

5.18

0.47

0.51

5x8

6.58

6.61

5.15

5.19

0.47

0.51

6x9

6.52

6.55

5.16

5.19

0.48

0.52

7x10

6.40

6.43

5.14

5.17

0.49

0.53

8x11

6.40

6.43

5.14

5.17

0.51

0.55

9x12

6.42

6.45

5.14

5.17

0.55

0.59

12x15

6.48

6.52

5.18

5.22

0.58

0.62

1x7

6.74

6.77

5.19

5.22

0.52

0.56

2x8

6.68

6.71

5.23

5.26

0.51

0.55

3x9

6.62

6.65

5.17

5.21

0.49

0.53

4x10

6.60

6.62

5.20

5.23

0.50

0.54

5x11

6.56

6.59

5.19

5.21

0.52

0.56

6x12

6.55

6.57

5.21

5.23

0.54

0.58

12x18

6.97

7.00

5.23

5.26

0.66

0.70

18x24

6.53

6.56

5.27

5.30

0.81

0.85

1x10

6.69

6.73

5.23

5.25

0.50

0.54

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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