A forward rate agreement (FRA) is a forward contract in which one party, the long, agrees to pay a fixed interest payment at a future date and receive an interest payment at a rate to be determined at expiration. It is a forward contract on an interest rate (not on a bond or a loan).
The fixed rate is also called the forward contract rate. The interest rate to be determined at expiration is also called the underlying rate.
The buyer effectively has agreed to borrow an amount of money in the future at the stated forward (contract) rate. The seller has effectively locked in a lending rate. The buyer of a FRA profits from an increase in interest rates. The seller of a FRA profits from a decline in rates.
Shell and Barclays enters into the following FRA:
By convention, this FRA is also referred to as a 1 x 3. At the expiration of the FRA in 30 days:
Note the market convention quotes the time periods as months, but the calculations use days based on the assumptions of 30 days in a months. For example, a "1 x 3 FRA" expires in 30 days, and the payoff of the FRA is determined by 60-day Libor when the FRA expires in 30 days.
|Seemorr: So you're not paying the absolute difference between the two rates ... you're paying the percentage difference.|
|Gooner7: those 2 numbers are the same thing|
|jpducros: note that expiration date = t1, not t2|
| freyalam: t2 is when payments are made|
(page 43, vol 6, the CFA institute textbook, for level 1)
|SCBAnalyst: t1 amount of payment is determined for actual payment in t2- hence the discounting|
|johntan1979: In Example 1, Shell receives a profit of $577.56|
| ankurwa10: as i understand, from the perspective of an end-user (long party)|
formula: (( underlying rate - agreed rate) ) x number of days to maturity/360) / 1+ underlying rate x number of days until maturity/360
Numerator: If interest rate rises (e.g. LIBOR is 6% and agreed rate is 5%, I make money); so calculate the differential i.e. 6% - 5% but then have to adjust the LIBOR for days until maturity.
Denominator: have to discount the amount by LIBOR discount, because we are agreeing to receive an interest amount relative to LIBOR, IN THE FUTURE.
Don't know if this is accurate though :P