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Forward Rate Agreement

Dr Amit Bagga
Forward Rate Agreement
FRA- It is a over the counter
agreement that a certain interest
rate will apply to either borrowing or
lending a certain principal during a
specified future period of time.
Consider a FRA where bank xx is
agreeing to lend money to company
zz for the period of time T1 and time
T2… Defined:
Rk –The rate of agreement to in the FRA
Rm -The actual Libor/ Mibor interest rate
observed in the market at time T1 for
the period between time T1 and T2
L- Principal amount

Time line of an FRA.

Trade date FRA start date/settlement date
Maturity date
T0 T1
Cash flow for bank xx(investor/lender) at
Time T2
L(Rk – Rm) (T2 - T1 )
Cash flow for company zz(borrower) at
time T2
L(Rm – Rk) (T2 - T1)

Note : Usually FRA’s are settled at time T1

rather than T2. The Payoff must be
So , the payoff for bank(Lender/investor) at
time T1
L(Rk – Rm) (T2 - T1 )
1 + Rm (T2 - T1 )

Payoff of company zz( borrower) at time T1

L(Rk – Rm) (T2 - T1 )

1 + Rm (T2 - T1 )
Mechanism of FRA

Buying of an FRA- When you want to

borrow money ,you buy an FRA. In
the above example company will buy
an FRA.
Selling of an FRA- When you want to
invest or lend money ,you sell an
FRA. In the above example bank will
sell an FRA.
Case 1
FRA for a borrower-
A firm plans to borrow £ 5 million for 3
months ,after 6 months from now. The
firm is apprehensive about the
possibility of rates rising over the
coming six months. He wishes to lock in
the cost of loan. Sterling 6/9 FRA is
being offered at 10.8750%. The
company decides to buy it .we will work
out the firm’s cost of borrowing of 3
month rate 6 months from today. The
anticipated borrowing is for 91 days and
The bank which sold the FRA
compensates the firm by
immediately paying an amount A
calculated as

A (0.1150 – 0.10875)X
1 + 0.1150(91/365)

Notice that the upfront payment by the FRA seller equals the
difference in interest on £ 5 million for 91 days at the actual
libor and the contracted rate, discounted at the actual libor.
Case 2

FRA for an Investor/lender.

A fund manager is expecting to have £
5 million, 3 month from now to invest
in a 3 month (92 days) deposit. The
current 3 month rates are 8.25-
8.375%. The 3/6 FRA bid rate is
8.1250%.Three month later the
settlement rate is 7.50%
The bank pays the manager an
amount A given by:

(0.08125 –
= (1+
Hedging of FRA risk with
Interest rate Future
For Borrower:
A borrower will always short interest rate
future in order to hedge the risk of
increase in interest rate with the
amount equivalent to the principal
amount .
For Investor/lender:
An investor will always long interest rate
future in order to hedge the risk of fall
in interest rate with the amount
Valuation of FRA

At time T0
Consider an FRA where we will receive a rate of 6%
on a principal of Rs 100 Million between the end
of year 1 and the end of year 2. The forward rate
is 5.127%

The value of FRA is = 100000000 X (0.06 –

Valuation of FRA

At time T1
A company enters into an FRA, receives a
fixed rate of 4% on a principal of Rs 100
Million for a 3 month period starting in
3years. If 3 month libor proves to 4.5% for
the 3 month period.

Value of FRA is = 100000000 X (0.04 – 0.045)X

0.25= -Rs1,25,000
At 3.25 year point -
this1is = to
+ 0.045 x
Rsa cash flow
of 0.25
Questions ?????