Practice question (forward rate agreement)

The table below shows the annual risk-free rates (annual, continuously compounded) for maturities of 1
to 5 years:

Maturities (years) rate (%)

1 2.0
2 3.0
3 3.7
4 4.2
5 4.5

a) Calculate the one-year annual forward interest rates (continuously compounded) for periods
starting in 1 year, 2 years, 3 years.

b) Use these rates to value an existing FRA with a borrower position. The FRA has a rate of 5%, a
notional amount of $1 million, and exchanges interest for 1 year for dates T 1=2 to T 2=3. The
annual forward rate (annual compounding) for a period starting in 2 years and ending 1 year later is
5.23%.
 Solution
a) The formula
R2 T 2 −R 1 T 1
R F=
T 2−T 1

 Forward rate for T 1=1 and T 2=2

0.03 × 2−0.02 ×1
R F , 1¿ 2 ¿= =0.04
2−1

 Forward rate for T 1=2 and T 2=3

0.037× 3−0.03× 2
R F , 2¿ 3 ¿= =0.051
3−2

b) Timeline of the problem

 The FRA can be valued as if the forward rate R F , 2à 3 (computed at t=0 ) is the LIBOR forward
rate that would be realized at T 1=2 years

 The value of the FRA with a BORROWER position (i.e. that promises to pay the rate R K =5 % )
today is therefore calculated as :

− R3 T 3
Value=L ×( RF −R K )×(T 2−T 1) ×e

Value=1 000 000 × ( 0.0523−0.050 ) × ( 3−2 ) × e−0.037× 3=2058.36