Demystifying Forward Rate Agreements (Calculations for CFA® and FRM® Exams)

Demystifying Forward Rate Agreements (Calculations for CFA® and FRM® Exams)

A forward rate agreement (FRA) is a cash-settled over-the-counter (OTC) contract between two counterparties, where the buyer is borrowing (and the seller is lending) a notional sum at a fixed interest rate (the FRA rate) and for a specified period starting at an agreed date in the future.

The purpose of FRA is to lock in borrowing or a lending rate for some time in the future. Typically, it involves two parties exchanging a fixed interest rate for a floating rate.

An FRA involves Two Counterparties:

The FRA buyer enters into the contract to protect itself from a future increase in interest rates; the seller of the FRA wants to protect itself from a future decline in interest rates.

Naming Convention

FRAs are denoted in the form of “X × Y,” where X and Y are months. So, a 1 × 4 FRA is called “1 by 4”.

A 1 × 4 FRA expires in 30 days (one month), and the theoretical loan is for a time period of the difference between 1 and 4 (three months = 90 days). That is, a three-month Libor determines the FRA’s payoff, but the FRA expires in one month.

Example 1: Understanding FRAs

A 3 × 9 FRA refers to:

A. A 90-day LIBOR loan starting 270 days from now.

B. A 270-day LIBOR loan starting 90 days from now.

C. A 180-day LIBOR loan starting 90 days from now.

Solution

The correct answer is C.

3-by-9 means a 180-day LIBOR loan starting 90 days from now.

FRA vs. Forwards

The forward rate specified in the FRA is compared with the current LIBOR rate, where: