Lesson 6 of 15
The forward contracts discussed thus far in the module have focused on situations where a buyer and seller want to lock in a future transaction price to buy/sell an asset such as a stock, a bond, or a foreign currency.
A forward rate agreement (FRA) enables a borrower to lock a fixed interest rate for borrowing and a lender to lock a fixed interest rate for lending.
The borrower (buyer, long the contract) in an FRA is seeking protection against rising interest rates and the lender (seller, short the contract) is seeking protection against falling interest rates.
FRAs are commonly tied to LIBOR.
FRA Price: An FRA's "price" is the fixed interest rate set at contract initiation; this is the rate that the contract buyer pays.
FRA Value: At contract initiation, an FRA's value is zero (just like other forwards). As interest rates move over the life of the contract, the fixed rate stays the same; the floating rate that will be set upon contract expiration is changing - thus, the one of the contract parties is gaining value and the other party is losing value.
Rising Rates: Fixed rate buyer is gaining value; alternatively, the seller is losing value.
Falling Rates: Fixed rate buyer is losing value; alternatively, the seller is gaining value.
Like equity forwards, fixed income forwards, and currency forwards, FRAs are priced at initiation and can be valued at any time during the contract's life and of course there are formulas associated with these.
The formulas associated with FRAs are not shown. Candidates are advised to perform practice conceptual problems for FRAs and then move on to understand the formulas.