Forward Rate Agreement

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Financial Derivatives and Risk Management (FDRM)

Term IV PGDM 2012-14

Syllabus
1. Introduction to Derivatives (C1) 2. Introduction to Forward and Futures Market (C2,C4) 3. Hedging Strategies using Forward/Futures Market (C3) 4. Determinants of Forward/Future Prices (C5) 5. Stock Index Futures (Reference Book) 6. Interest Rate Futures (C6) 7. Swaps (C7)

Chapter 2 Introduction to Forward and Futures Market

Chapter 2 Introduction to Forward and Futures Market

1. FRA 2. Valuation of FRA 3. Mechanism of the Futures Market

1. Forward Rate Agreement (FRA)


An FRA is an OTC agreement designed to ensure that a certain interest rate will apply to either borrowing or lending a certain principal during a specified future period of time. Means at time 0, the forward rate has been locked (F(0,t1,t2) and the loan period starts from t1.

FRA-Notations
The principal in FRA is notional and used to calculate the interest The borrowing or lending starts at t1 and remains there for t2 but the agreement is done at t=0.
t=0 t=t1 t=t2

The fixed rate in FRA is know as forward rate and shown by F(0,t1,t2).

FRA-Notations
r(t1,t2) is the annual rate with annual compounding for the period (t2-t1) existing in the spot market at time t1 (settlement date) .
t=0 t=t1

t=t2

Agreement date or Trade date

FRA Start date or Settlement Date

FRA Maturity Date

FRA
Long in FRA Means taking or borrowing the notional amount for (t2-t1) period at F(0,t1,t2) rate starting at t1 time. Short in FRA means lending the notional amount for (t2-t1) period at F(0,t1,t2) rate starting at t1 time.

FRA
Loan Duration
t=0 t=t1 t=t2

Example Suppose a bank anticipates fall in the interest rates. The bank goes for selling the FRA of following term and condition. 2M*5M FRA at F(0,2M,5M)=6% If on t1 (after 2 months) interest rates are r (2M,5M)=4.8% per annum find out the profit or loss for the bank. (Notional Capital is $500 Million)

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