Fixed Income and Credit Risk

Prof. Michael Rockinger

B - 2 - Forward Products
FRAs

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Learning Objectives

Forward Rate Agreements (FRAs)

Definitions

Forward rate of an FRA

Value of a FRA at any time

Usefulness of a FRA: Example

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Forward Rate Agreement (FRA) (PV162)
FRA is a non-cash contract (upon writing, no money is paid) between two
counterparties ageed upon at time t (today) such that:
One counterpart agrees to pay the forward rate fn (0, T1 , T2 ) on a given
notional amount N at the contract maturity T2 = T1 + ∆.
This counterpart will receive at T2 a market floating rate rn (T1 , T2 ) that is not
observed until T1 .
The other counterpart agrees to receive forward rate and to pay variable rate
The net payment for the counterpart who pays fixe and receives variable at
maturity T2 is then given by:

N∆ (rn (T1 , T2 ) − fn (0, T1 , T2 )) .

Here, ∆ = T2 − T1 is typically a quarter (0.25) or six months (0.5), while n = 1/∆

denotes the corresponding compounding frequency: n = 4 for quarterly and n = 2
for semi-annual periods.
Non-cash means that it costs nothing to enter a FRA at time t.
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Valuation of a FRA
At time T1 the rate r(T1 , T2 ) is known
-
t=0 T1 T2 Time
-
6
?

Here nothing happens at T1 all the CF payments take place at T2

One counterpart receives a variable amount N∆r(T1 , T2 )
This counterpart pays a fixed amount N∆f (0, T1 , T2 )
In reality pays only the net amount (which can be negative) in which case it
receives

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Valuation of a FRA: FRA Rate
At inception, FRA is worth 0
Payoff at T for paying fixed (like long position) is

N∆ (rn (T1 , T2 ) − fn (0, T1 , T2 )) .

The question is how can one ‘discount the math symbols’

N∆rn (T1 , T2 ).
can be generated by placing N into a deposit till T1 then reimburse a credit
that expires at T2 of N
Value at t = 0 of this is N(Z(0, T1 ) − Z(0, T2 )).
Discounting −N∆fn (0, T1 , T2 ) is trivial since this is a constant reimbursement
that needs to be made at T2
Total value at t = 0 is N(Z(0, T1 ) − Z(0, T2 )) − N∆fn (0, T1 , T2 )Z(0, T2 )

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Valuation of a FRA: FRA Rate

At inception, FRA is worth 0

Total value at t = 0 is N(Z(0, T1 ) − Z(0, T2 )) − N∆fn (0, T1 , T2 )Z(0, T2 ) = 0
Hence
Z(0, T1 ) − Z(0, T2 )
fn (0, T1 , T2 ) =
∆Z(0, T2 )
And we recover the formula for n-compounded forward rate:

Z(0, T1 )
1 + ∆fn (0, T1 , T2 ) =
Z(0, T2 )

Rate on LHS, ratio of short over long on RHS

The FRA rate is the same as the forward rate!

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Valuation of a FRA over time: t < T1
For t < T1 one discounts the terminal payoff as when one construct the value
at t = 0 of FRA

V fra (t, T1 , T2 ) = N(Z(t, T1 ) − Z(t, T2 )) − N · ∆ · fn (0, T1 , T2 )Z(t, T2 )

Since at t we have a new forward rate:

Z(t, T1 ) − Z(t, T2 )
fn (t, T1 , T2 ) =
∆Z(t, T2 )

One can substitute

Z(t, T1 ) − Z(t, T2 )
above and obtain immediately the formula

V fra (t, T1 , T2 ) = Z(t, T2 ) · N · ∆ · (fn (t, T1 , T2 ) − fn (0, T1 , T2 ))

Obtain value of FRA by replacing unknown future interest by forward

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Valuation of a FRA over time: T1 < t < T2

In this case the interest rate rn (T1 , T2 ) is perfectly known

V fra (t, T1 , T2 ) = Z(t, T2 ) · N · ∆ · (rn (T1 , T2 ) − fn (0, T1 , T2 ))

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Valuation of a FRA over time summary

Suppose three months after the inception of the contract (July 27, 2020) the
firm decides to close its FRA with the bank.

V fra (t, T1 , T2 ) = Z(t, T2 ) · N · ∆ · (fn (t, T1 , T2 ) − fn (0, T1 , T2 ))

For T1 < t < T2 we have:

V fra (t, T1 , T2 ) = Z(t, T2 ) · N · ∆ · (rn (T1 , T2 ) − fn (0, T1 , T2 ))

Knowing those values is useful for risk-management

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FRA: Usefulness illustrated

Recall the firm with receivable of $100 million in six months on October 28, 2020
(T1 ). Today is April 28, 2020 (t). The firm wishes to invest this amount for
additional six months until April 28, 2021 (T2 ) at a predetermined rate. The firm
can enter into a six-month FRA with the bank for the period T1 to T2 , and notional
N = $100 million.
The bank agrees to pay at T2 the amount N · 0.5 · f2 (0, 0.5, 1), where
f2 (0, 0.5, 1) is the current semi-annually compounded forward rate for the
period T1 to T2 . The firm agrees to pay at T2 the amount N · 0.5 · r2 (0.5, 1),
where r2 (0.5, 1) is the semi-annually compounded spot interest rate as of T1 .
At T1 the firm receives $100 million and invests this amount at the market
interest rate r2 (0.5, 1).
The bank hedges the interest rate risk with T-Bills as before.

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FRA: example (continued)
Net cash flow at T2 for the firm is:
!
r2 (0.5, 1)
CF Firm
(T2 ) = N 1 + + N · 0.5 · (f2 (0, 0.5, 1) − r2 (0.5, 1)) =
2
!
f2 (0, 0.5, 1)
=N 1+ = $102.105 million
2
Recall that the forward rate was: f2 (0, 0.5, 1) = 4.21%
The bank is now exposed to interest rate risk, as the FRA yields a negative
payoff if f2 (0, 0.5, 1) > r2 (0.5, 1). The bank hedges the interest rate risk with
T-Bills today (as before):

CF Bank (T2 ) = −N · 0.5 · (f2 (0, 0.5, 1) − r2 (0.5, 1)) + 1.02105 · N−

!
r2 (0.5, 1)
−N 1 + =0
2

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 Hedge of a FRA (PV164)
150 INTEREST RATE DERIVATIVES: FORWARDS AND SWAPS

Table 5.3 Trading Strategy to Compute Forward Rate

Today (Time 0) T1 T2

(a) Borrow $100 m ! "

Sell short $97.728 m of T-bills r2 (0.5,1)
at rate r2 (0.5, 1) Pay $100 m × 1 + 2
maturing at T1
(b) Close short position

Buy M = 1.02105 = $97.728

$95.713 Receive 1.02105 × $100 m
of T-bills maturing at T2

100 m
Enter FRA with Firm Pay 2
× [f2 (0, 0.5, 1) − r2 (0.5, 1)]
Total Net Cash Flow = 0 Total Net Cash Flow = 0 Total Net Cash Flow = 0

5.2.1 The Value of a Forward Rate Agreement

When two counterparties enter into a FRA, there is no exchange of money at the time of12 / 12