Hedging with an FRA means using a forward rate agreement (FRA) to protect yourself from changes in interest rates in the future. An FRA is a contract between two parties that sets a fixed interest rate for a loan or deposit that will start at a specified date in the future and last for a certain period. The loan or deposit amount is not exchanged, but only the difference between the fixed rate and the market rate at the start of the loan or deposit is paid by one party to the other.
For example, suppose you want to borrow $1 million in six months for three months, and you are worried that interest rates will rise by then. You can buy an FRA today that sets a fixed rate of 5% for a three-month loan starting in six months. This is called a 6v9 FRA. If the market rate for a three-month loan in six months is 6%, you will receive a payment from the seller of the FRA that equals the difference between 6% and 5% on $1 million for three months. This payment will offset the higher interest cost of your loan. On the other hand, if the market rate is 4%, you will have to pay the seller of the FRA the difference between 4% and 5% on $1 million for three months. This payment will reduce the lower interest benefit of your loan. In either case, your effective interest rate on the loan will be 5%, the same as the FRA rate.
Hedging with an FRA can also be done by depositors who want to lock in a certain interest rate for their future deposits. They can sell an FRA that sets a fixed rate for a deposit that will start at a specified date in the future and last for a certain period. If the market rate for the deposit is lower than the FRA rate, they will receive a payment from the buyer of the FRA that equals the difference between the FRA rate and the market rate on the deposit amount for the deposit period. If the market rate is higher than the FRA rate, they will have to pay the buyer of the FRA the difference between the market rate and the FRA rate on the deposit amount for the deposit period. In either case, their effective interest rate on the deposit will be the same as the FRA rate.
Hedging with an FRA can help you reduce the uncertainty and risk of interest rate fluctuations in the future. However, it also means that you will not be able to benefit from favorable changes in interest rates.
Basic Theory:
A Forward Rate Agreement (FRA) is a financial derivative that allows parties to lock in an interest rate today for a future period. It’s essentially a contract where one party agrees to pay a fixed interest rate and, in return, receives a floating interest rate based on a reference rate, such as LIBOR.
Procedures:
- Identify the Exposure: Determine the interest rate risk exposure that needs to be hedged. This could be related to future borrowing costs or investment returns.
- Select the FRA Terms: Choose the FRA contract terms, including the notional amount, the fixing date (when the reference rate is determined), and the settlement date (when payments are exchanged).
- Calculate the FRA Rate: Use the following formula to calculate the FRA rate:
FRA Rate = ((Rfloating - Rfixed) × Day Count) / (1 + Rfloating × Day Count)
Excel Implementation:
- Step 1: Set Up the Excel Table: Create a table with columns for Notional Amount, Fixed Rate, Floating Rate, Day Count, Fixing Date, and Settlement Date.
- Step 2: Input Data: Enter the relevant data into the table. For example, Notional Amount = $1,000,000, Fixed Rate = 4%, Floating Rate = 3%, Day Count = 90, Fixing Date = 01/01/2024, Settlement Date = 01/04/2024.
- Step 3: Calculate FRA Rate: Use the Excel formula to calculate the FRA rate:
=((B2 - C2) * E2) / (1 + C2 * E2) - Step 4: Calculate Cash Flow: Determine the cash flow at settlement using the FRA rate:
=A2 * (D2/360) * (C2 - F2)
Scenario:
Let’s consider a scenario where a company plans to borrow $1,000,000 in three months and wants to hedge against potential interest rate increases. The company enters into a 3-month FRA with a notional amount of $1,000,000, a fixed rate of 4%, and a floating rate of 3%.
Result:
The FRA rate is calculated using the provided formula, resulting in a rate of approximately 4.01%. The cash flow at settlement is then determined to be around $2,250.
Other Approaches:
- Multiple FRAs: Instead of a single FRA, a company may use multiple contracts with staggered fixing and settlement dates to create a series of hedges.
- Interest Rate Swaps: Consider using interest rate swaps, where two parties exchange interest rate payments, often converting fixed rates to floating rates or vice versa.
- Options: Explore interest rate options, providing the right but not the obligation to enter into an interest rate agreement in the future.
