5 Forward Rate Agreement Let us have an example with an 1x4 FRA one fourth FRA

5 forward rate agreement let us have an example with

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Forward Rate Agreement Let us have an example with an 1x4 FRA (“one-fourth” FRA). This is a three-month loan beginning one month from now. The date when the contract is agreed is called dealing date . The spot date is usually two business days afterwards. This means that the settlement date is within one month, counting from the spot date . On the fixing date , two days before settlement date, the difference between contract rate and reference rate is determined. On the settlement date the settlement payment, amount due, is exchanged. The final maturity date is after 4 months of the dealing date . There are no more payments to be made. The exact term of the FRA is determined; final maturity – settlement date = days of FRA term. (Ref: and Financial Engineering) 6. Features of Forward Rate Agreement Under FRA itself no lending or borrowing takes place. Two parties agree to pay or receive settlement sum in the future, based on the difference between the contract rate and reference rate r ref - r FRA Seller of the FRA – notionally lends a particular sum of money to the buyer and fixes the rate for lending or investing. Is protected against fall in interest rates but if r ref > r FRA must pay the difference to the buyer Buyer of the FRA – notional borrower, is protected against raise in interest rates but if r ref < r FRA must pay the difference to the seller. 6
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Forward Rate Agreement r ref – the most common reference rate used under FRAs are: EURIBOR, ETONIA used in the euro zone, TIBOR in Japan, SIBOR in Singapore, and LIBOR (London) is also used for other currencies (Dollar, Euro, Yen, Franc, Krone, ect). (Ref: Financial Engineering) In our case, we will take the LIBOR (London Interbank Offered Rate) as a reference rate. LIBOR is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The LIBOR is fixed on a daily basis by the British Bankers' Association. The LIBOR is derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with maturities between overnight and one full year. (Ref: ) The LIBOR is the world's most widely used benchmark for short-term interest rates. It's important because it is the rate at which the world's most preferred borrowers are able to borrow money. It is also the rate upon which rates for less preferred borrowers are based. For example, a multinational corporation with a very good credit rating may be able to borrow money for one year at LIBOR plus four or five points. (Ref: ) The relevant LIBOR rate to be used when determining the reference rate depends on the FRA’s maturity. For example, in case of 2x6 FRA with a maturity of 4 months (6 – 2 = 4), the FRA formula will be compared with LIBOR rate of 4 month maturity.
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  • Fall '10
  • Bart Vinck
  • Interest Rate, ........., Money market, FRAS

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