Forward Rate Agreement

Forward Rate Agreement - The forward rate of interest for...

Info iconThis preview shows pages 1–7. Sign up to view the full content.

View Full Document Right Arrow Icon
Forward Rate Agreement A forward rate agreement (FRA) is an agreement that a certain rate will apply to a certain principal during a certain future time period 1
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Forward Rate Agreement continued An FRA is equivalent to an agreement where interest at a predetermined rate, RK is exchanged for interest at the market rate 2
Background image of page 2
FRA definitions RK = The rate of interest in the FRA RF = The forward LIBOR rate for the time between T1 and T2 today L = The principal underlying the loan 3
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
FRA Valuation The value of a forward contract can be positive or negative depending on what happens to rates. The value of a contract in which the party agrees to PAY the forward rate in exchange for RK is VFRA = L (T2-T1)(RK-RF)e(-R2*T2) 4
Background image of page 4
FRA Example What is the value of an FRA in which the holder earns 9.5% for the three-month period starting in one year?
Background image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Background image of page 6
Background image of page 7
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: The forward rate of interest for three months beginning in 1 year is 9.102%. The zero interest rate for 15 months is 8.6% with continuous compounding. The principal is $1,000,000 and the forward interest rates are expressed with quarterly compounding. 5 FRA Example Continued This FRA has positive value because, according to the agreement, the holder earns a rate that is higher than the current forward rate. VFRA= 1,000,000(.25)(.095-.09102)e-0.086*1.25 = $893.59 6 Theories of the Term Structure Page 93 Expectations Theory: forward rates equal expected future zero rates Market Segmentation: short, medium and long rates determined independently of each other Liquidity Preference Theory: forward rates higher than expected future zero rates 7...
View Full Document

This note was uploaded on 01/19/2012 for the course FIN 4520 taught by Professor Lucyackert during the Spring '12 term at Kennesaw.

Page1 / 7

Forward Rate Agreement - The forward rate of interest for...

This preview shows document pages 1 - 7. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online