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.
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:
OTC Options:
will be published shortly,
Part 3 Topics:
- Interest rate Caps, Collars and Floors
- Interest rate swaps
- IRD Clearing process
