Part 2 of Interest Rate Derivatives: Forward Rate Agreement and OTC Options

Welcome to the Part 2 of Interest Rate Derivatives series. In this part, I am going to explain Forward Rate Agreement (FRA), benefits and usage of FRA, key terminologies and an example explaining the scenarios for profit and loss.

Furthermore, I am going to add OTC options, benefits and usage of OTC options with example.

You can refer to below link of Part 1 of this series. In the first part  I have covered  interest rate derivatives, factors affecting the interest rates, exchange traded financial futures and an approach for calculating profit and loss for financial futures. 

 Part 1 of Interest Rate Derivatives (IRD)

Forward Rate Agreement

The forward rate agreement is an OTC (Over the counter) derivative product. Like exchange traded future derivatives product, one of the main purposes of FRA is to allow borrower and lender to hedge the risk of interest rates movements and fixing the interest rates for future.

The FRA is a legally binding contract between two parties to determine the rate of interest applied to a notional or loan, of an agreed amount for a specific period of time on a specific date (settlement date).

One of the parties is a buyer and other is seller of the FRA. The buyer agrees to borrow the money on notionally on FRA/Fixed Rate and the seller agrees to lend the money notionally on FRA. On the settlement date the difference between the agreed fixed/FRA rate and the prevailing reference rate (LIBOR in most cases) will be settled in cash between buyer and seller.

Forward Rate Agreement:

·         FRA is a tailor-made, over-the-counter financial futures contract for short-term deposit.

·         FRA transaction is a contract between two parties to exchange payments on a deposit, called the Notional amount, to be determined on the basis of a short-term interest rate, referred to as the Reference rate, over a predetermined time period at a future date.

·        The buyer of the contract locks in the interest rate in an effort to protect against an interest rate increase, while the seller protects against a possible interest rate decline.

·        Typically FRA dealers are Banks /iBanks.

An example would help to illustrate the need of FRA and mitigation of the Interest rate risks using FRA.

The Pragyan Limited needs £5M in Jan, which it can repay back in Feb. In order to hedge against the risk that the interest rates may be higher in Jan than it is in currently running month (Nov), the company enters into a FRA with Bank X at 7% fixed rate (FRA rate).

In this case it would be a 2x3 FRA, meaning a 1 month loan to begin in 2 months, with a notional principal of £50,00,000. On Jan 2 2013, if the interest rate rises to 8%, Bank X would pay Pragyan Limited the increased amount arising from the higher interest rate/reference rate. If reference interest rate falls to 6%, Pragyan will pay the difference to Bank X.

This arrangement will allow Pragyan to hedge against the adverse interest rate movement and provide fixed interest rate. If Bank X is anticipating drop in interest rates after couple of months then it’s a good opportunity for Bank X to make profit without making initial investment.

Key Benefits of FRA:

Benefits	Description
Insurance	The bank will guarantee a rate of interest for a transaction which starts on future date. The client is legally obligated to transact at that rate, so is “locked” into the FRA interest rates.
Cash Settlement	The difference between the FRA rates and ruling market will be settled by the parties.
Profit Potential Flexibility	For the hedger- nil. For trader (buyer or seller) any cash received under the FRA is profit. If FRA is no longer required, a reversed transaction may be transacted to close out (novate) the position.
Zero Cost	It’s a zero cost derivatives and no premium required to be paid.

Difference between the FRA and Future exchange traded contracts

Like Exchange traded future contract FRA is also used for hedging the risk of interest rate movements. The key differences between FRA and exchange traded future product are followings

Key Differences	Exchange Traded Future Derivative	FRA	Comments
Regulation and Governance	Regulated and executed by the Exchange.	Regulated and executed outside Exchange. In future, clearing and creation of FRA will be notified to global trade repository and regulated by Dodd frank regulations.	Because FRA is an OTC product and hasn’t been regulated by a specific governing body. There are Credit and Operation risks involved in FRA transactions. But the risks are minimal because FRA doesn’t lend the money, it is typically used to hedge the money on notional.
Collateral	Require Initial margins and variation margins get calculated each business day.	Doesn’t necessary require collateral Typically cash settled on settlement date.	Exchange traded future contract requires initial collateral/margins and margins (variation margins) gets calculated each business day on each position. Whereas, FRA doesn’t require collateral.
Calculation and settlement of profit	Profit and loss gets calculated on each business day and final settlement happens the day position gets closed.	Profit and loss gets calculated on settlement date.	In case of FRA, settlement date is typically the start date of the FRA. Profit will be discounted because it’s paid in the beginning of the contract.

 

Clearing process of FRA

FRA is an OTC derivative product. This means that it’s a direct agreement between buyer and seller. In most cases agreement between buyer and seller is covered by Master Service agreement. Up-till now, OTC trades weren’t regulated and there were no compliance or regulatory requirements of clearing the trades via central clearing party (CCP).

Dodd frank regulations now make it mandatory to get all the trades (except OTC trades related with soft commodities) via CCP and each party including buyer, seller and CCP need to submit the information to the Global Trade Repository (GTR).

Please refer to Part 4 of this series for clearing process.  

Key Terminologies

Terminology	Definition
Settlement date	The start date of the underlying loan or deposit.	Cash settlement happens on this date.
Maturity date	The date on which the FRA contract period ends.
Reference rate	Reference index rates	e.g. LIBOR, EURIOR
Fixed rate	Fixed rate agreed between the buyer and seller	Also referred as FRA rate
Day count fraction (α)	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.

Interpretation of  Notations

Key Notation	Effective date from current date	Termination/Maturity date from effective date	Typical Underlying rate
1x4	One month from the current date	Three months from the effective date	4-1=3 months LIBOR/EURIOR rate
2x5	Two months from the current rate	Three months from the effective date	5-2=3 months LIBOR/EURIOR rate
2x3	Two months from the current rate	One month from the effective date	3-2= 1 month LIBOR/EURIOR rate
1x7	One month from the current date	Six months from the effective date	7-1= 6 months LIBOR/EURIOR rate
6x12	Six months from the current date	Six months from the effective date	12-6= 6 months LIBOR/EURIOR rate

How to calculate profit and loss

Consider the previous example of Pragyan Limited. In the month of Nov, due to unforeseen circumstances Pragyan must find £5 million for expenditure to occur on Jan 2 2013. Pragyan expects to generate revenue, and the company expects to be able to repay this amount on Feb 2013. Pragyan has number of ways to meet this expenditure, in this example I am only considering two approaches traditional loan and FRA.

Let's assume Pragyan can normally borrow funds for 1 month from its local bank at a rate of 1 month Libor plus 100 basis points (bps). If the company takes the first alternative, the effective interest rate it would be able to borrow at would remain unknown until Jan 2 2013, when it borrows the actual £5 million at 1 month LIBOR plus 100 bps.

Note that this represents a variable interest rate, as the interest rate in 2 months remains unknown until the actual day arrives. What if the company wishes to know on Nov 2 2012 the interest they must pay on the loan, which will not occur for another 2 months.

Pragyan can also get a quote from a FRA dealer (normally a bank). In this example, the company needs a 2x3 FRA quote (with 2x3 meaning one month loan, to begin in 2months). Let's assume the FRA dealer offers a quote of 7.0%.

If Pragyan accepts the FRA rate of 7.0% on Nov 2, then 2 months later (Jan 2), it will settle in cash this difference between the previously agreed upon 7.0% and 1 month LIBOR on Jan 2 2013. If the 1 month LIBOR on Jan is lower than 7.0%, the company must pay the FRA dealer. However, if it is higher, the company receives payment from the FRA dealer. Since the company is effectively borrowing at a lower interest rate than otherwise possible if the 1 month LIBOR is higher than 7.0%, and as such receives payment.

To calculate the amount of the payment, refer to the formula below.

Potential events on settlement date (Jan 2 2013 )	Pragyan Limited	Bank	Calculations and Comments
If one month LIBOR is at 7%	No cash settlement required	No cash settlement required	FRA rate is equal to the reference rate (LIBOR in this case )
If one month LIBOR is at 8%	Will receive the discounted difference of 1%	Will pay the discounted difference of 1%	α = 30/365= 0.08219 Notional amount= £50,00,000 Reference Rate = 8% FRA rate/Fixed rate= 7% Payment = Notional Amount* (Reference Rate- FRA rate)* α Payment = 50,00,000 * (8-7)%*.08219 Payment =£4,109.59 Pragyan is going to get this payment in the beginning of the contract, which means we need to discount this payment using time value of money concepts. Discounted Payment = Payment/(1+Reference rate * α) Discounted Payment=4109.59/(1+8%*.08219) Discounted Payment=£4,082.74
If one month LIBOR is at 6%	Will pay the discounted difference of 1%	Will receive the discounted difference of 1%	α = 30/365= 0.08219 Notional amount= £50,00,000 Reference Rate = 6% FRA rate/Fixed rate= 7% Payment = Notional Amount* (Reference Rate- FRA rate)* α Payment = 50,00,000 * (6-7)%*.08219 Payment =-£4,109.59 Bank is going to get this payment in the beginning of the contract, which means we need to discount this payment using time value of money concepts. Discounted Payment = Payment/(1+Reference rate * α) Discounted Payment=4109.59/(1+6%*.08219) Discounted Payment=£4,089.42 Total Cost of borrowing to Pragyan Limited Interest @6% = £50,00,000*6%                          = £3,00,000 Discounted Interest rate= Interest * α                                            =£24,657 Total Cost =Discounted (Payment to bank+  Interest rate                    =£28,746

Conclusion

Future Rate Agreement (FRA) offers banks and other financial institutions excellent heading and trading opportunities. FRA is a tailor made OTC product and usually provides liquidity to the traders. FRA contractually binds buyer and   seller, if at any point of time buyer would like to close the FRA position then a reversed transaction is required to novate the position. Unlike options it doesn't provide the flexibility of "right to buy"  without obligation. 

OTC Options:
will be published shortly,

Part 3 Topics:

•  Interest rate Caps, Collars and Floors
• Interest rate swaps

Part 4 Topics:

• IRD Clearing process 

Interest Rate Derivatives - Part 1

Interest rate derivative (IRD) is a derivative product, which is used mainly to hedge the risk associated with interest rates movement.  In IRD, the underlying asset is the right to pay or receive the notional amount at a given interest rate. IRD is mainly used by the institutional investors such as banks, iBanks etc.

Like other derivatives products there are two parties involved in a transaction, IRD doesn't lend money to traders or investor rather it’s typically used to manage the risk associated with interest rates movements.

Following are the list of IRD products. These products also have been classified as  Vanilla, semi-vanilla (Quasi-Vanilla) and Exotic derivatives.  The selection of these products depends on the maturity period and the liquidity required.

Maturity Period	Typical classification  of the IRDs and its usage
< 1 year	Very Short term Vanilla products - generally require most liquidity Exchange Trades Futures FRA OTC Interest rate options
1-2 years	Short term Vanilla products/Semi-vanilla products   Exchange Trades Futures FRA Interest rate Caps, Collars and Floor
2-5 years	Medium term Semi-Vanilla and Exotic products FRA Interest rate Caps, Collars and Floor  Interest rate Swaps
5-10 years	Long term Exotic products Interest rate Caps, Collars and Floor  Interest rate Swaps

What is interest rate risk?

Interest rate is the cost of borrowing the money. It’s a rate on which depositor will deposit the money and borrower will borrow it. The depositor is taking risk of lending the money on a specific rate and borrower is taking risk of borrowing the money on a specific rate.  The volatility in the interest rates movement is a risk for both borrower and depositor of increased funding cost or reduced yield for the investor. 

The factors which typically affect the interest rates are

·         Demand and Supply of the credit-

An increase in the demand for the credit will increase the interest rates, while decrease in demand will decrease the interest rates. For example – when we open a bank account, basically we are depositing money with bank. Bank can use this money for other investment purposes (depends on proposed Volcker' rule implementation in future). Assume, if bank is getting regular cash flow from the depositors (which means us ), equal to the demand from borrowers or out flow then Bank may not need to borrow the money from other financial institutions, which may result into lending it bit cheap to its borrowers.

     ·        Inflation-

Inflation affects interest rate levels. The higher the rate of inflation, the more interest rates are likely to rise. This occurs because lenders would like to demand higher interest rates as compensation for the decrease in the purchasing power of the money they will be repaid in the future.
Inflation plays a major role in determining the returns on the investment or deposit. Government time to time regulates or issue bonds to control the inflation.  In case of Fx trades or sovereign bonds, inflation is considered to be one of the key parameters.

    ·        Govt. financial policies and  control-

In order to meet short term demand and supply typically financial institutions/banks borrow the money from each other. In USA, federal fund rate is charged for short term loans. The fed influences these rates by buying or selling previously issued securities. By buying the securities, fed provides more money to the banks and by selling it, fed takes away the liquidity from the banks.

Typically, Repo (repurchase) rate or reverse repo rates are the two terminology used for buying or selling the securities. In India, RBI (Reserve bank of India), as part of  Financial and  Credit policy, controls the interest rates movements, by changing the base, repo and reverse repo rates.

Derivatives Products

Type of Settlement	List of products
Single settlement products	Exchange traded financial futures OTC – Forward rate agreements OTC Interest rates options	These are the instruments have one fixing/settlement during the lifetime of a transaction.
Multiple settlement products	Interest rate Caps, Collars and Floors Interest rate swaps	These are the instruments have more than one fixing/settlement during the lifetime of a transaction.

                   

The scope of Part one of this series is to cover Exchange traded financial futures.

What are Exchange-traded: financial futures

     ·   Futures are primarily used by the banks, large financial institutions and large multinational    industries to hedge and trade interest rates positions.

     ·  Futures are legally binding agreement between the parties at future date at the agreed price   between the parties.

     ·  Future Contract will not actually lend the money. It’s just to protect the interest rate movement.

     ·  Short term Future Contracts are quoted on the “index basis” typically LIBOR.

     ·  Future Contracts are designed to buy at low and sell it high or vice-versa

Contracts Available – Different Future Contracts are available in different currencies. Common short-term interest rate futures are in Eurodollar, Euribor, Euroyen, Short Sterling and Euroswiss, which are calculated on LIBOR at settlement, with the exception of Euribor which is based on Euribor.

For graphs and other future rates contract, refer to below link

http://www.cmegroup.com/trading/interest-rates/stir/1-month-libor_quotes_globex.html

Abbreviated Contract Format-

This is abbreviated format of the contract. The main purpose is to provide the understanding of key elements.

Key Elements	Example of Values	Definition for better understanding, not part of actual contract
Unit of trading	£5,00,000	Contract Size
Delivery Month	March, June, Sep, Dec	Delivery month is the month in which seller must deliver to buyer. Financial future contract such as bonds, Short term interest rates tend to expire quarterly.
Last trading day	11:00 AM last trading day of the month	Last trading day of the Delivery month.
Quotation	100 minus the rate of interest
Minimum price movement	.01%	Tick, refer below for the definition
Hours	7:30 -18:00
Trading Platform	LIFFE Connect	London International Financial Futures and Options Exchange.

    

Market Operations-

Both buyer and seller must put up minimum margin/collateral for each open contract. The actual margin amount is calculated by exchange in conjunction with clearing house typically using standard portfolio analysis of risk (SPAN) developed by Chicago Merchandise Exchange in 1988. SPAN is used to calculate the risk for future/options portfolio and assess the margin requirements.

Positions are marked-to-market on a daily basis by comparing the level on the client’s trade and the settlement price on that day. Profit and loss are developed daily. If positions loose the money during the day then client must pay his losses and if position gains then client gets the profit. These daily payments are known as “Variation Margins”.

How to calculate profit and loss

Key terminologies

Terminology	Definition	Comments/Example
Tick	Each tick represent market moment of 0.01%
Tick Size/ Minimum fluctuations	The tick size is known as the minimum price change.	For example, the EUR futures market has a tick size of 0.0001, which means that the smallest increment that the price can move from 1.2902, would be up to 1.2903, or down to 1.2901.
Tick value	Value of a tick for calculating profit and loss Formula – Tick value =Contract size * minimum tick size moment* notional time deposit underlying the contract.	For example Euro currency ->contract size 5,00,000-> 3 months contract size-> tick value 5,00,000*.01%*3/12=12.50 (tick value)
Typical Calculation of Risk (1% Risk  )	There is no hard and fast rule but many professional traders adhere to 1% risk. This means that no more than one percent of trading amount can be put on risk on each trade. The reason for the one percent risk rule is to keep the maximum possible loss for each trade at an acceptable amount, and to make sure that no single trade has the ability to blow up a trading account (i.e. lose so much money that the account cannot be traded). A trader generally uses this approach to find out the value of Spot loss.	Example- The one percent risk rule for a €30,000 trading account, making a short futures trade on a market with a €10 tick value, with an entry price of €4,125, and a stop loss price of €4,150, would be calculated as follows: Maximum Capital = €30,000 *1% = €300 Trade Size = €300 / ((€4,125 - €4,150) x 10) = 1 contract (actually 1.2 contracts, but this is not possible) The maximum size of the example futures trade is one contract, because if the trade makes a loss (by trading at its stop loss price), the one contract will lose €250 (which is less than 1% of the trading account).
Initial Margins	In order to mitigate the credit risk of both the counterparties, the clearing house will take some collateral/margin at the time of trading. This is known initial margin.	Assume the initial margin is £400 per contract on the short sterling future. It the client had opened a position of 10 contracts then he would have to deposit with exchange   400*10=£4000 The extend of daily losses should not exceed the initial margins. For example, £400 per contract represents a possible loss of 400/tick value (12.50 )=32 ticks or .32% movement in the implied interest rates. If clearing house felt that there is a potential of greater loss because of excessive volatility then they may ask for more initial margin or collateral.
Variation Margins	At close of business every day, each open position is marked to market and compared with day’s official settlement price. If the position is in profit or , the margin account will be credited or debited with the profit or loss. These payments are known as variation margins.	Example – Consider a client who has taken a view those interest rates will fall. He turns out to wrong. On each day his initial position will make some loss that he must fund on a daily basis. If the original trade was of 10 contracts and the initial margin was £400 per contact (total of - £4000) If position moved against him by 20 ticks per contract 20*10*12.50=£2500 Clearing house will deduct £2500 from his initial margin of £4000. The balance money £1500 can only support 3 future contract (rounded).  This means he need to add £2500 otherwise exchange will close out any un-margined   outstanding contracts.

     Example of calculating Profit and Loss – At the beginning of October a trader feels that Euro interest rates will fall by Dec. The current 3 months LIBOR rates today is , say, 4.15%, he wishes to make profit form the downward movement of in rates, his trading amount is £5m.

He bought 10 contract of 3 months sterling interest rate future at the current level of 100-4.15= 95.85

In the month of Dec, 3 months LIBOR rates is 3.65 percent, he decided to close out his position.

He bought 100-4.15= 95.85

He sold 100-3.65=96.35

Profit - .50 = 50 Ticks

                        The total profit trader had made in this process –

                        10 contracts * 50 ticks *12.50 each tick =£6250

Example of hedging

A trader of a larger Indian Company would like to borrow £5M on 20^th Dec. He has no requirement of cash today. But, he has invested in a venture that requires him to invest £5M for a period of 3 months. He believes that sterling interest rates will rise. The current LIBOR rates are 5.5 %. The current future markets rates for Dec are 5.8%. This means that market is already anticipating interest rates hike. The trader decides to hedge with futures.

Date	Action
10th Dec	Short	Trader sells (short) 30 Dec short sterling futures at the current level of 94.20. Over the next few months, treasurer receives/pay daily variation margins.
20th Dec	-Borrow the money from internbank@6.7 -Close out the future position	Interest rates increases and trader borrows the money from the interbank market at 6.7%. He then closes out his future position by buying the future contract at prevailing rates of 93.3.

Profit -Calculation of profit/hedging with future

Sno	Potential Action	Month	Potential interest	Comments
1	50,00,000 @5.5% for 3 months	Oct	£2,75,000	If borrowed the money in the Month of Oct then the trader would have paid £2,75,000 as interest.
2	50,00,000 @5.8% for 3 months	Oct (implied future rates)	£2,90,000	If borrowed the money at future interest rate then the trader would have paid £2,90,000 as interest rate.
3	50,00,000 @6.7% for 3 months	Dec	£3,35,000	Money made after closing the future position. 94.20-93.3= 90 ticks Contracts -10 Tick value – 12.50 Profit – 90*10*12.50= £11,250
4	50,00,000 borrowed for 3 months	Dec	£3,35,000-£11,250=£3,23,750 @6.475 lower than the prevailing rates	Actual interest paid £3, 23,750 after adjusting the profit from future.

Conclusion-
Futures offer banks and other financial institutions excellent hedging and trading opportunities. At-times, it gets difficult for companies to manage a portfolio of future contract efficiently. In addition to the documentations, the user must install the system to monitor the margins and accounting , manage risk and settlement date etc. Financial future can be packed into a friendly product, known as FRA (Forward Rate agreement ).

Part 2 Topics:(Click here link for part 2)
 ·        Forward rate agreement, benifits and usage of FRA, key terminologies and an example explaining the scenarios for profit and loss.
 ·       OTC: interest rate options, benefits and usage of OTC options with example.