Question 1 FIN30021 Fixed Income and Debts Markets Week 3 11 Forwards, Futures and Options a. What is a forward rate agreement? · The FRA is a contractual agreement, between two parties, relating to an interest rate level that will apply at a specified future date. A borrower that needs to borrow funds in seven months can lock-in an interest rate today that will apply in seven months. . The FRA effectively allows the parties to the agreement to lock-in a rate of interest that will apply at the specified future date based on a notional principal amount. b. What are the main features of an FRA? Explain how a corporation that needs to borrow funds in seven months can use an FRA to fix the cost of funds today. . The agreement relates to the interest rate; no exchange of principal takes place. . The final settlement between the parties to the agreement is the value of the difference between the FRA agreed interest rate and the reference interest rate that exists on the settlement date. . An FRA can usually be entered into for periods of up to two years. · An FRA is a compensation agreement; one party will compensate the other party, based on the notional principal amount, for any adverse movement in the FRA settlement rate relative to the FRA agreed rate. · The FRA will specify: 1. the FRA agreed rate; fixed at the start of the FRA 2. the notional principal amount of the interest cover 3. the FRA settlement date when compensation is paid 4. the contract period on which the FRA interest rate cover is based (end date) 1
5. the reference rate to be applied at settlement date. c. What are the main differences between an FRA and a futures contract? 1.The FRA is an over-the-counter product. 2. A futures contract is an exchange traded contract. Futures contracts are standardised. 3. An FRA can be negotiated to meet a risk manager's specific needs in relation to amount and contract period 4.Futures contracts require margin payments; the FRA does not 5.Futures contracts are guaranteed by the clearing-house; with the FRA counterparty risk is evident d. What are the advantages and disadvantages for this instrument? Advantages: Disadvantages: · Flexibility . Low transaction costs · Market depth · Settlement · Not formal market · Forfeit possible gains · Credit risk Question 2 You know that in seven months' time your company is going to borrow $5 million for six months. You obtain the following quotes from an FRA dealer: 6Mv7M(23) 10.35 to 25 7Mv13M(23) 10.50 to 20 You enter into an FRA with the dealer: a. What will be the FRA agreed rate? . The FRA quote 7Mv13M states that the dealer is quoting seven months forward on 6-month money (therefore disregard first quote). Also the FRA quote of 10.50 - 20 means that the dealer is 2
prepared to buy (lend) at 10.50% per annum and sell (borrow) at 10.20% per annum.