Forward Rate Agreement (FRA) Product and Valuation Alan White FinPricing

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Presentation transcript:

Forward Rate Agreement (FRA) Product and Valuation Alan White FinPricing

FRA Summary ◆ Forward Rate Agreement (FRA) Introduction ◆ The Use of FRA ◆ FRA Payoff ◆ Valuation ◆ Practical Guide ◆ A real world example

FRA FRA Introduction ◆ A FRA is a forward contract between two parties in which one party will pay a fixed rate while the other party will pay a reference rate for a set future period. ◆ FRAs are cash-settled OTC derivatives with the payment based on the net difference between the floating (reference) rate and the fixed rate in the contract. ◆ Similar to a swap, a FRA has two legs associating with each party: a fixed leg and a floating leg. But each leg only has one cash flow. ◆ The party paying the fixed rate is usually referred to as the buyer, while the party receiving the floating rate is referred to as the seller. ◆ FRAs are money market instruments that are liquid in all major currencies.

FRA The Use of FRA ◆ A FRA can be used to hedge future interest rate exposure. ◆ The buyer hedges against the risk of rising interest rate whereas the seller hedges against the risk of falling interest rates. ◆ In other words, the buyer locks in the interest rate to protect against the increase of interest rates while the seller protects against the possible decrease of interest rates. ◆ A speculator can also use FRAs to make bets on future directional changes in interest rates. ◆ Market participants can also take advantage of price differences between an FRA and other interest rate instruments.

FRA

Practical Guide (Cont) ◆ To use the formula, you need to compute simply compounded forward rate instead of other compounding types. ◆ The accrual period is calculated according to the start date and end date of a cash flow plus day count convention ◆ We assume that accrual periods are the same as forwarding periods and payment dates are the same as accrual end dates in the above formulas for brevity. But in fact, they are slightly different due to different market conventions.

FRA A Real World Example Leg 1 SpecificationLeg 2 Specification CurrencyUSDCurrencyUSD Day CountdcAct360Day CountdcAct360 Leg TypeFixedLeg TypeFloat Notional Notional Pay ReceivePayPay ReceiveReceive Start Date4/7/2017Start Date4/7/2017 End Date10/10/2017End Date10/10/2017 Settlement Date10/10/2017Settlement Date10/10/2017 Fixed Rate Spread Index Specification TypeLIBOR Tenor6M Day CountdcAct360

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