Sunday, 25 November 2007

What is FRAs?

If you have flipped through the newspapers, you may have come across this acronym known as the FRAs. What is FRAs then? A forward rate agreement (FRA) can be viewed as a forward contract to borrow/lend money at a certain rate at some future date. In practice, these contracts settle in cash, but no actual loan is made at the settlement date.

This means that the credit worthiness of the parties to the contract need not be considered in the forward interest rate, so an essentially riskless rate, such as LIBOR, can be specified in the contract. The long position in an FRA is the party that would borrow the money (long the loan with the contract price being the interest rate on the loan). If the floating rate at contract expiration (LIBOR or Euribor) is above the rate specified in the forward agreement, the long position in the contract can be viewed as the right to borrow at below market rates and the long will receive a payment. If the reference rate at the expiration date is below the contract rate, the short will receive a cash payment from the long.

To calculate the cash payment at settlement for a forward rate agreement, we need to calculate the value as of the settlement date of making a loan at a rate that is either above or below the market rate. Since the interest savings would come at the end of the "loan" period, the cash payment at settlement of the forward is the present value of the interest "savings". We need to calculate the discounted value at the settlement date of the interest savings or excess interest at the end of the loan period.

For those who are not sure what is LIBOR? It is the lending rate on dollar-denominated loans between banks and is actually known as London Interbank Offered Rate or simply LIBOR.

LIBOR is published daily by the British Banker's Association and is compiled from quotes from a number of large banks; some are large multinational banks based in other countries that have London offices. There is also an equivalent Euro lending rate called Euribor, or Europe Interbank Offered Rate. Euribor, established in Frankfurt, is published by the European Central Bank.

The floating rates are for various periods and are quoted as such. For example, the terminology is 30-day LIBOR (or Euribor), 90-day LIBOR, and l80-day LIBOR, depending on the term of the loan. For longer-term floating rate loans, the interest rate is reset periodically based on the then-current LIBOR for the relevant period.

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