Talk:Forward rate agreement

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[edit] Relationship to overnight index swap

How is a forward rate agreement related to an overnight index swap? Finnancier (talk) 12:19, 15 December 2007 (UTC)

[edit] definition of FRA

I do consider the given definition of Forward Rate Agreement or FRA in Article page as wrong.
The given definition is for a swap.

A FRA is an agreement where two parties agree today (t0) for the rate of a short term loan in the future.
The rate could also refer to a long term treasury bond, but usually it is something with a short term.
It is best explained with a sample.
Imagine you would like to borrow 10 million EUR in 3 months (t1) for 6 months (t2).
And you agree with the counterparty that the rate is 4%.
So the rate of your FRA 3x9 is 4%.

The FRA expires in 3 months.
Situation 1: The 6 month Euribor went up to 4.25%. (t1)

Instead of receiving a loan of 10 million EUR for 6 months from your counterparty you will settle the FRA with the counterparty. This is to reduce the risk that you will default.

In t1 you take up a loan of 10 million EUR for 6 months for 4.25%.

Your interest in t2 will be 4.25% * 10 million * 180/360 = 212,500

Based on your FRA the interest is only 4% * 10 million * 180/360 = 200,000

In t2 you will pay 12,500 EUR "too much" interest.

Your counterparty will compensate you in t1 for your loss in t2. We do discount the 12,500 from t2 to t1 (12,500 / (1 + 4.25% * 180/360)) = 12,240 Now, in t1 you will receive 12,240 EUR from your counterparty.

Situation 2: The 6 month Euribor went down to 3.75%. (t1)
Instead of takeing up a loan of 10 million EUR for 4% you will go to the money market and take up a loan for 3.75% and settle the FRA with the counterparty.

You promised your counterparty to make in t2 an interest payment of 200,000 EUR (see Situation 1)

Instead you only need to pay 3.75% * 10 million * 180/360 = 187,500 EUR.

This time your counterparty is going to loose 12,500 EUR in t2. And you need to compensate them now in t1 buy paying them 12,240 EUR.
Matjung (talk) 20:39, 28 March 2008 (UTC)