Forward Rate Agreement

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

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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

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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
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

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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
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?

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

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

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