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Trading and Capital-Markets Activities Manual

Instrument Profiles: Forward Rate Agreements
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)


A forward rate agreement (FRA) is an over-the-counter (OTC) contract for a cash payment at maturity based on a market (spot) rate and a pre-specified forward rate. The contract specifies how the spot rate is to be determined (this is sometimes called the reference rate). If the spot rate is higher than the contracted rate, the seller agrees to pay the buyer the difference between the pre-specified forward rate and the spot rate prevailing at maturity, multiplied by a notional principal amount. If the spot rate is lower than the forward rate, the buyer pays the seller. The notional principal, which is not exchanged, represents a Eurocurrency deposit of a specified maturity or tenor, which starts on the day the FRA matures. The cash payment is the present value of the difference between the forward rate and the spot rate prevailing at the settlement date times the notional amount. This payment is due at the settlement date. Buying and selling FRAs is sometimes called taking and placing FRAs, respectively. FRAs with maturities longer than a year are called long-dated FRAs. 

FRAs are usually settled at the start of the agreed-upon period in the future. At this time, payment is made of the discounted present value of the interest payment corresponding to the difference between the contracted fixed rate (the forward rate at origination) and the prevailing reference rate (the spot rate at maturity). For example, in a six-against-nine-month (6x9) FRA, the parties agree to a three-month rate that is to be netted in six months' time against the prevailing three-month reference rate, typically LIBOR. At settlement (after six months), the present value of the net interest rate (the difference between the spot and the contracted rate) is multiplied by the notional principal amount to determine the amount of the cash exchanged between the parties. The basis used in discounting is actual/360-day for all currencies except pounds sterling, which uses an actual/365-day count convention. 


An FRA can be entered into either orally or in writing. Each party is, however, required to confirm the FRA in writing. FRAs are customized to meet the specific needs of both parties. They are denominated in a variety of currencies and can have customized notional principal amounts, maturities, and interest periods. The British Bankers' Association (BBA) has developed standards for FRAs, called Forward Rate Agreements of the BBA (FRABBA) terms, which are widely used by brokers and dealers. The standards include definitions, payment and confirmation practices, and various rights and remedies in case of default. Under these standards, counterparties execute a master agreement, under which they agree to execute their FRA transactions. 



FRAs are often used as a hedge against future movement in interest rates. Like financial futures, they offer a means of managing interest-rate risk that is not reflected on the balance sheet and, therefore, generally requires less capital. 

FRAs allow a borrower or lender to ''lock in'' an interest rate for a period that begins in the future (assuming no change in the basis), thus effectively extending the maturity of its liabilities or assets. For example, a financial institution that has limited access to funds with maturities greater than six months and has relatively longer-term assets can contract for a six-against-twelvemonth FRA, and thus increase the extent to which it can match asset and liability maturities from an interest-rate risk perspective. By using this strategy, the financial institution determines today the cost of six-month funds it will receive in six months' time. Similarly, a seller of an FRA can lengthen the maturity profile of its assets by determining in advance the return on a future investment. 


Banks and other large financial institutions employ FRAs as a trading instrument. Market makers seek to earn the bid/ask spread through buying and selling FRAs. Trading may also take the form of arbitrage between FRAs and interest-rate futures or short-term interest-rate swaps. 


Primary Market 

Commercial banks are the dominant player in the FRA market, both as market makers and end-users. Non-financial corporations have also become significant users of FRAs for hedging purposes. Most contracts are originated in London and New York, but all major European financial centers have a significant share of volume. Market transparency is high in the FRA market, and quotes for standard FRA maturities in most currencies can be obtained from sources such as Telerate and Bloomberg. 

A significant amount of trading in FRAs is done through brokers who operate worldwide. The brokers in FRAs usually deal in Euros and swaps. The principal brokers are Tullet & Tokyo Foreign Exchange; Garvin Guy Butler; Godsell, Astley&Pearce; Fulton Prebon; and Eurobrokers. 

Secondary Market 

The selling of an existing FRA consists of entering into an equal and opposite FRA at a forward rate offered by a dealer or other party at the time of the sale. The secondary market in FRAs is very active and is characterized by a significant amount of liquidity and market transparency. 


Initial Cost 

When an FRA is initiated, the FRA rate is set such that the value of the contract is zero, since no money is exchanged, except perhaps a small arrangement fee (which may not be payable until settlement). Forward rates are directly determined from spot rates. For example, the rate on a 6-against-12-month FRA will be derived directly from rates on 6- and 12-month deposits. (This rate derived from the yield curve is termed an implied forward rate.) As an example, suppose the 6-month Eurodollar deposit rate is 6.00 percent and the 12-month Eurodollar deposit rate is 7.00 percent. The rate on a 6-against-12-month FRA would be derived by finding the 6-month forward rate, 6 months hence (6R12): 


There is little evidence that arbitrage opportunities exist between the FRA and deposit markets after taking into account bid/offer spread and transactions costs. 

Valuation at Settlement 

Settlement on an FRA contract is made in advance, that is at the settlement date of the contract. The settlement sum is calculated by discounting the interest differential due from the maturity date to the settlement date using the relevant market rate. 

Let f = the FRA rate (as a decimal), s = the spot rate at maturity (as a decimal), t = the tenor of the notional principal in number of days, P = the notional principal, and V = the sum due at settlement. Assume that the basis is actual/360-day. The interest due the buyer before discounting is (s - f)P(t/360). The discount factor is 1 -s(t/360). V is the sum due at settlement: 

V = [(s - f)P(t/360)][1 - s(t/360)] 

For example, consider a $10 million three-against-six-month FRA with a forward rate of 6.00 percent and a spot rate at maturity of 6.50 percent. 

V = [$10mm(.065 - .06)(91/360)]
 [1 - ((.065)(91/360))] 
V = $12,431.22 

A payment of $12,431.22 would be made by the seller to the buyer of the FRA at settlement. 


Market Risk Eurodollar futures are usually used to hedge the market risk of FRA positions. However, the only perfect economic hedge for an FRA is an offsetting FRA with the same terms. 

Credit Risk 

Letters of credit, collateral, and other credit enhancements can be required to mitigate the credit risks of FRAs. In practice, however, this is rarely done because the credit risk of FRAs is very low. 


Interest-Rate Risk 

The interest-rate risk (or market risk) of an FRA is very similar to a short-term debt instrument with maturity equal to the interest period of the FRA. For example, a six-against-nine-month FRA has a price sensitivity similar to that of a three-month debt instrument (approximate duration of one-fourth of a year). 

Liquidity Risk 

Liquidity risk (the likelihood that one cannot close out a position) is low. The FRA markets are very liquid, although generally not as liquid as the futures markets. 

Credit Risk 

The credit risk of FRAs is small but greater than the credit risk of futures contracts. The credit risk of futures is minimal because of daily margining and the risk management of the futures clearing organizations. If an FRA counterparty fails, a financial institution faces a loss equal to the contract's replacement cost. The risk of loss depends on both the likelihood of an adverse movement of interest rates and the likelihood of default by the counterparty. For example, suppose a financial institution buys an FRA at 10 percent to protect itself against a rise in LIBOR. By the settlement date, LIBOR has risen to 12 percent, but the counterparty defaults. The financial institution therefore fails to receive anticipated compensation of 2 percent per annum of the agreed notional principal amount for the period covered by the FRA. Note that the financial institution is not at risk for the entire notional principal amount, but only for the net interest-rate differential. 

FRAs raise the same issues about measuring credit-risk exposure as interest-rate swaps. Because the periods covered by FRAs are typically much shorter, many institutions calculate the credit exposure on FRAs as a flat rate against the counterparty's credit limit, for example, 5 percent (sometimes 10 percent) of the notional principal amount. The 5 percent credit exposure is a rule of thumb adopted for administrative ease, and it represents the approximate potential loss from counterparty default if the reference interest rate for a three-month future period moves against the financial institution by 20 percentage points before the settlement date. For an agreement covering a six-month future interval, the 5 percent charge to a counterparty's credit limit represents exposure against approximately a 10 percentage point movement in the reference interest rate. 


The accounting treatment of single-currency forward interest-rate contracts, such as forward rate agreements, is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.) 


The credit-equivalent amount of an FRA contract is calculated by summing- 

 1. the mark-to-market value (positive values only) of the contract and 
 2. an estimate of the potential future credit exposure over the remaining life of each contract. 

The conversion factors are below. 

Remaining Maturity                        Factor 
One year or less                             0.00% 
Five years or less                           0.50% 
Greater than five years                    1.50% 

If a bank has multiple contracts with a counterparty and a qualifying bilateral contract with the counterparty, the bank may establish its current and potential credit exposures as net credit exposures. (See section 2110.1, ''Capital Adequacy.'') For institutions that apply market-risk capital standards, all foreign-exchange transactions are included in value-at-risk (VAR) calculations for market risk. 


FRAs are not considered investments under 12 USC 24 (seventh). The use of these instruments is considered to be an activity incidental to banking, within safe and sound banking practices. 


Andersen, Torben. Currency and Interest Rate Hedging. Simon and Schuster, 1993. 
Das, Satyajit. Swap and Derivative Financing. Chicago: Probus Publishing, 1993. Francis, Jack, and Avner Wolf. The Handbook of Interest Rate Risk Management. Irwin Professional Publishing, 1994. 
Stigum, Marcia. The Money Market. Dow Jones-Irwin, 1990. 4315.1 Forward Rate Agreements


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