In
finance, a forward rate agreement (FRA)
is a forward contract in which one party pays a fixed
interest rate, and receives a floating interest rate equal
to a reference rate (the underlying rate). The payments
are calculated over a notional amount over a certain period,
and netted, i.e. only the differential is paid. It is
paid on the effective date. The reference rate
is fixed zero, one or two days before the termination
date, dependent on the market convention for the particular
currency. FRAs are over-the counter derivatives. A swap is a combination
of FRAs.
The
payer of the fixed interest rate is also known as the
borrower or the buyer, whilst the receiver of the fixed
interest rate is the lender or the seller.
Payoff
formula
The
netted payment made at the termination date is:
- The
Fixed Rate is the rate at which the contract is agreed.
- The
Reference Rate is typically Euribor or LIBOR.
- α
is the day count fraction, i.e. the portion of
a year over which the rates are calculated, using the
day count convention used in the money markets in the
underlying currency. For EUR and USD this is generally
the number of days divided by 360, for GBP it is the
number of days divided by 365 days.
- The
Fixed Rate and Reference Rate are rates that should
accrue over a period starting on the termination date,
and then paid at the end of the period. However, as
the payment is already known at the beginning of the
period, it is also paid at the beginning. This is why
the discount factor is used in the denominator.
FRAs
Notation
FRA
Descriptive Notation and Interpretation
| Notation |
Termination date from now |
End of period from now |
Underlying Rate |
| 1 x 3 |
1 month |
3 months |
3-1 = 2 months LIBOR |
| 1 x 7 |
1 month |
7 months |
7-1 = 6 months LIBOR |
| 3 x 6 |
3 months |
6 months |
6-3 = 3 months LIBOR |
| 3 x 9 |
3 months |
9 months |
9-3 = 6 months LIBOR |
| 6 x 12 |
6 months |
12 months |
12-6 = 6 months LIBOR |
| 12 x 18 |
12 months |
18 months |
18-12 = 6 months LIBOR |
See
also
