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 |
|