Forward Rate Agreements

Session 3 – Derivatives & Risk Mgt

 What are spot rates?
• Spot rates – the interest rate applicable for a specific
period starting from today
• Also known as zero coupon rates
• Spot rate curve constructed from spot rates for
various maturities
• Spot rates are not directly observed in the market
• Derived from the normal yield curve by the
bootstrapping method
 What are forward rates?
• Suppose an investor has a one-year investment horizon
• He has 2 alternatives:
▪ Buy a 1-year Treasury Bill
▪ Buy a 6-month Treasury Bill and after it matures in six
months, buy another 6-month T-Bill
• The investor will be indifferent between the 2 alternatives when
both alternatives give him the same return over his one year
horizon
• Investor knows the spot rates on the 6-month T-Bill and 1-year T-
Bill
• What will be the spot rate for a 6-month T-Bill purchased 6
months from now?
 Why compute forward rates?
• Forward rates implied from current spot rates indicate the
interest rates expected to prevail in the future
• An investor’s strategy will depend on whether his expectations
are different from that of the market
• Example
– An investor wants to invest Rs.50 lakhs for a one-year horizon
– He can either invest directly for one year at the one-year spot rate or
invest for six months at the 6-month rate and renew the deposit at the
end of 6 months at the rate prevailing then
– The six month spot rate is 7% and the one-year spot rate is 6%
– This implies a rate of 5% for the six-month period starting 6 months
from now
– What will the investor do?
 Computation of forward rates
When period is less than 1 year, the general formula is

Where rf is forward rate, rl = long-

term deposit rate, rs=short-term
deposit rate, nl =number of days in
long term, ns=number of days in
short-term and nf=number of days
in forward period
 Computation of forward rates
When period is more than 1 year, the general formula is
(1+rl)nl/12 = (1+rs)ns/12 * (1+f)nf/12
Where rl = rate for long period and nl =number of months in long
period, rs = rate for short period and ns=number of months in short
period, f =forward rate and nf =number of months in forward period
 An example

An investor has a 5-year investment

horizon. Should he (a) Invest in a 5-year
bond or (b) Invest in a 2 year-bond
today and roll over the maturity
proceeds into a 3-year bond?

Investment for 5 years starting today will yield (1+.095)^5

Investment for 2 years starting today will yield (1+.088)^2
Investment for 3 years starting 2 yrs from now will yield (1+f)^(3)
Hence f =(( (1+.095)^5)/((1+.088)^2))^(1/3)-1
The implied 3-year forward rate starting 2 years from now is 9.97%
If the investor’s view is that the 3-year interest rate 2 years from now will
be lower than 9.97%, he should go for (a) else go for (b)
 Forward Rate Agreements
• A product to hedge against interest rate
fluctuations for short periods
• Can be used to lock in a rate of interest for a
borrowing or investment for a fixed period
starting n periods from now
• Can be used for hedging against expected rise
as well as decline in interest rates
 Mechanics of the FRA
• The party with a long position enters into an agreement at time
T0 to borrow from the party with the short position
• a predetermined amount P
• at a fixed interest rate k
• for the period [T1, T2]
• There is no exchange of principal at any time under the FRA
• The difference between the reference rate at time T1 denoted
by l and the agreed upon fixed rate k, if positive (negative), is
received (paid) by the long position fro the short position
• This difference is settled at time T1 by discounting the
cashflows from T2 to T1
 Pricing a new FRA
•  
 Pricing a new FRA - example
• Suppose the current 3-month and 6-month
LIBOR rates are 4% and 4.50%. Assuming
that there are 92 days in the first 3-month
period and 91 days in the second three-month
period what is the price of a new 3 X 6 FRA?
 Valuing an existing FRA
•  
 FRA valuation example
• Consider the 3X6 FRA of the earlier example.
The principal amount is Rs.25,00,000. One
month has passed since entering into the FRA.
Assume that the current 2-month and 5-month
interest rates are 5.50% and 6% respectively,
what is the value of the FRA today? Assume
that there are 61 days in the first two-month
period and 91 days in the next three-month
period.
 Borrower’s FRA
• A company wants to borrow Rs.50 crore three months
from now for a project which will take around 6
months. Its current borrowing cost is 9%. The
Company anticipates the central bank to raise interest
rates in December. The bankers are quoting a 3/9
FRA at 9.25%-9.75%. How can the Company hedge
against the rise in interest rates? What will be the
effective cost of borrowing for the Company if the
interest rate is 10% at the end of three months from
today? What if interest rate is at 8%?
 Investor’s FRA
• A company expects a cash dividend of Rs.50 crore
from its subsidiary three months from now. The CFO
does not anticipate any requirement for these funds
for a period of 6 months. Six-month bulk deposit rate
is around 8.50% today. The CFO apprehends a
decline in interest rates around December. The
bankers are quoting a 3/9 FRA at 8.45%-8.75%. How
can the Company hedge against a decline in interest
rates? What will be the effective yield earned on the
deposit if the interest rate is 8 % at the end of three
months from today? What if interest rate is at 9%?