A forward rate agreement (FRA) is a contractual agreement between two parties to lock-in a future interest rate on a loan or investment. It is often used by companies to manage interest rate risk. In this article, we will explore a FRA sample problem to better understand how FRAs work.
Problem Statement:
ABC Company is planning to borrow $1 million in six months` time for a period of two years. The current interest rate for a two-year loan is 5%. However, ABC Company is concerned about the possibility of interest rates increasing in the future, which would increase their borrowing costs. To hedge against this risk, ABC Company enters into a FRA with XYZ Bank.
The FRA is for a notional amount of $1 million and has a settlement date in six months` time. The agreed upon forward rate is 6%. The FRA specifies that if the interest rate on the two-year loan at the settlement date is greater than 6%, XYZ Bank will pay ABC Company the difference between the actual interest rate and the forward rate. If the interest rate is less than 6%, ABC Company will pay XYZ Bank the difference.
Calculate the cash flows for ABC Company and XYZ Bank if the interest rate at the settlement date is 7%.
Solution:
The first step is to calculate the interest payments for the two-year loan at 7%. The interest payment for the first year will be $50,000 (5% of $1 million) and the interest payment for the second year will be $52,500 (5.25% of $1 million).
Next, we need to calculate the settlement payment for the FRA. The settlement payment is the difference between the actual interest rate and the forward rate, multiplied by the notional amount.
For ABC Company:
Settlement payment = (7% – 6%) x $1 million = $10,000
ABC Company will receive $10,000 from XYZ Bank as the interest rate on the loan is greater than the forward rate.
For XYZ Bank:
Settlement payment = (7% – 6%) x $1 million = $10,000
XYZ Bank will pay $10,000 to ABC Company as the interest rate on the loan is greater than the forward rate.
Conclusion:
In this FRA sample problem, we saw how a company can use a FRA to hedge against the risk of interest rates increasing in the future. By entering into a FRA, the company can lock-in a future interest rate, which helps them to plan their cash flows better. A FRA can also help a company to reduce the impact of interest rate volatility on their financials. It is important to note that while a FRA can protect against interest rate risk, it also involves risks and costs, which should be carefully considered before entering into the agreement.
