A forward rate agreement (FRA) is a type of interest rate derivative that allows two parties to fix the interest rate on a loan or deposit that will be made in the future. The FRA specifies the notional amount, the fixed interest rate, the reference interest rate, and the period of the loan or deposit. The FRA is settled in cash at the beginning of the loan or deposit period, based on the difference between the fixed rate and the reference rate at that time.
FRAs are used to hedge against interest rate risk, or to speculate on the future movements of interest rates. For example, a borrower who expects interest rates to rise can enter into an FRA to lock in a lower interest rate for a future loan. A lender who expects interest rates to fall can enter into an FRA to lock in a higher interest rate for a future deposit.
Basic Theory
The basic idea behind FRAs involves a fixed interest rate (the agreed-upon rate) and a reference interest rate (the market rate) determined at the contract’s initiation. The settlement amount is based on the difference between these two rates, applied to a notional principal amount.
The formula for calculating the settlement amount is:
Settlement Amount = Notional Principal × Notional Period × (Agreed Rate – Market Rate) × Day Count Factor
where:
- Notional Principal is the principal amount on which the interest rate is applied.
- Notional Period is the time period (in years) for which the FRA is contracted.
- Agreed Rate is the fixed interest rate agreed upon in the contract.
- Market Rate is the reference interest rate prevailing in the market at the contract initiation.
- Day Count Factor is a factor that accounts for the actual number of days in a year based on a specific day-count convention.
Procedures in Excel
- Input Parameters:
- Calculate the Settlement Amount:
- Create an Excel Table:
Enter the Notional Principal, Notional Period, Agreed Rate, Market Rate, and Day Count Factor into designated cells.
Use the formula mentioned earlier to calculate the Settlement Amount in a specific cell.
Organize your data into a table format for better readability and future analysis.
Scenario Example
In this scenario:
- Notional Principal: $1,000,000
- Notional Period: 3 months (0.25 years)
- Agreed Rate: 5%
- Market Rate: 4.5%
- Day Count Factor: 90/360 (assuming a standard day-count convention)
Excel Table for Scenario
| Parameter | Value |
|---|---|
| Notional Principal | $1,000,000 |
| Notional Period | 0.25 years |
| Agreed Rate | 5% |
| Market Rate | 4.5% |
| Day Count Factor | 90/360 |
| Calculation | Formula | Result |
|---|---|---|
| Settlement Amount | (1,000,000 × 0.25 × (0.05 – 0.045) × (90/360)) | $1,250 |
In this scenario, the FRA settlement amount is $1,250.
