Forward rate agreements

Forward rate agreements (FRAs) are forwards on time deposits. In a FRA, one party
agrees to pay a specific interest rate on a Eurodeposit of a specified currency,
maturity, and amount, beginning at a specified date in the future. FRA prices are
defined as the spot rate the buyer agrees to pay on a notional deposit of a given
maturity on a given settlement date. Usually, the reference rate is Libor. For example,
a 3î6 (spoken ‘3 by 6’) Japanese yen FRA on óY 100 000 000 can be thought of as a
commitment by one counterparty to pay another the difference between the contracted
FRA rate and the realized level of the reference rate on a óY 100 000 000
deposit.
Suppose the three-month and six-month Swiss franc Libor rates are respectively 3.55% and 3.45%. Say Bank A takes the long side and Bank B takes the short side
of a DM10 000 000 3î6 FRA on 1 January at a rate of 3.30%, and suppose threemonth
DM Libor is 3.50%. If the FRA were settled by delivery, Bank A would place a
three-month deposit with Bank B at a rate of 3.30%. It could then close out its
position by taking a deposit at the going rate of 3.50%, gaining 0.002î 90
360î
10 000 000ó5000 marks when the deposits mature on 1 June.
FRAs are generally cash-settled by the difference between the amount the notional
deposit would earn at the FRA rate and the amount it would earn at the realized
Libor or other reference rate, discounted back to the settlement date. The FRA is
cash-settled by Bank B paying Bank A the present value of DM5000 on 1 March.
With a discount factor of 1.045î 90
360ó1.01125, that comes to DM4944.38.