module 5 fra

8/8/2019 Module 5 FRA

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Refer to International Financial Management by PG Apte and International FinancialManagement by Vyuptakesh Sharan for further details

Module 5

Management of Interest Rate Exposure

FRA

Fluctuations in interest rate affect a firms cash flows by affecting interest income on

financial assets and interest expenses on liabilities. In other words, the market values ofa firms portfolio of financial assets and liabilities fluctuate with interest rates. For a non

financial firm, fluctuations in interest rates causes corresponding fluctuations in

operating earnings and rates of return on projects.

Effective assessment and management of interest rate exposure requires first of all a

clear statement of the firms risk objectives as follows:

Primary Objectives:

1. Net interest income i,e interest income on assets interest expense on

liabilities. Monitoring of this account will reveal the sensitivity of the firms

profitability to changes in interest rates (suitable for a non financial

corporation with relatively few financial assets)

2. Net equity exposure I,e sensitivity of the firms net worth to interest rates

(suitable for a financial institution with predominantly financial assets and

liabilities)

Secondary Objectives

1. Credit Exposure which is really a measure of default risk.

2. Basis risk arises when interest rate exposure on one instrument e.g

commercial paper is offset with another instrument e.g Eurodollar futures or

when floating rate assets tied to one index. E.g T-bill rate are funded by

floating rate liabilities tied to another index e.g LIBOR

3. Liquidity risk pertains to timing mismatches between cash inflows and

outflows e.g when a longer duration asset is funded by a shorter duration

liability which will have to be refunded at maturity possibly at a higher cost.

This is known as gap risk.

Forward Rate Agreements

FRA is notionally an agreement between two parties in which one of them (the seller of the

FRA) contracts to lend to the other (FRA buyer) a certain amount of funds in a particular

currency, for a specified period starting at a specified future date, at an interest rate fixed

at the time of agreement.

A typical FRA quote from a bank might look like this:

SJCC/MIB II/Foreign Exchange Management/Module 5 - FRA/VA Page 1

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USD 6/9 months: 7.20 7.30% p.a

This is to be interpreted as follows:

The bank is willing to accept a 3-month USD deposit i,e borrow funds, starting 6

months from now, maturing 9 months from now, at an interest rate of 7.20% p.a(bid rate)

The bank is willing to lend dollars for a period of 3 months, starting 6 months

from now at an interest rate of 7.30% p.a (the ask rate)

If the settlement rate (L) on the settlement date is above the contract rate (R) the seller

compensates the buyer for the difference in interest on the agreed upon principal amount

for the duration of the period in the contract. Conversely, if the settlement rate is below the

contract rate, the buyer compensates the seller.

The compensation is paid up front on the settlement day and therefore, has to be suitable

discounted since interest payment on short term loans is at the maturity of the loan. Thefollowing formulas are used for calculating settlement payment from the seller to the buyer.

When, L>R, P = [(L-R)*DF*A] / [(B*100)+ (DF*L)]

Also, can be written as [(L-R)*DF/360*A] / (1+ L*DF/360)

When, L < R, P = [(R-L)*DF*A] / [(B*100)+ (DF*L)]

Where, L: settlement rate %

R: contract rate %

DF: number of days in the contract period

A: notional principalB: day count basis (360 or 365)

Illustration: FRA and the borrower

Consider the 6-9 FRA quotation:

USD 6/9 months: 7.20 7.30% p.a

Suppose a company which intends to take a 3 month loan starting 6 months from now

wishes to lock in its borrowing rate. It buys the FRA from the bank which is giving the above

FRA quotes, at the banks ask rate of 7.30% for an underlying notional principal of USD 5 M.suppose on settlement date, the reference rate e.g USD LIBOR is 8.5%. The number of days

in the contract period is 90 and the basis is 360 days. The bank will have to pay the

company:

P = [(L-R)*DF*A] / [(B*100)+ (DF*L)]


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= USD [(8.5-7.3)*90*5M] / [(360*100) +(90*8.5) ]

=USD 5.4 M / 36765

= USD 0.01468 M

OR, [(0.085-0.073)*5M*90/360] / (1+ 0.085*90/360)

= 0.015 M/ 1.02125 = 0.01468 M

The numerator is the extra interest the company will have to pay because the actual

borrowing rate is higher than the contract rate. This will be paid at the expiry of the loan.

The FRA seller pays the company the present value of this, discounted at the actual rate viz,

8.5% for 90 days at the start of the loan.

FRA and the lender

A lender buys FRA when interest rate is expected to drop. Suppose the present rate of

interest is 8%. The amount of future borrowing is $ 100,000. The maturity is 3 months. The

fallen interest rate is 7%. If the lender buys an FRA, the ,loss will be compensated by theseller of the FRA. The seller will pay:

[(R-L)*DF/360*A] / (1+ L*DF/360)

= [(0.08 0.07)*90/360*100,000] / (1+0.07*90/360)

= 250/1.0175

=USD245.70

FRA In India

The Indian government allowed FR contracts in July 1999 along with interest rate swaps andissued detailed guidelines to regulate them. In a majority of these contracts, the National

stock exchange Mumbai inter bank offer rate (NSE-MIBOR) and Mumbai Inter bank

forward offer rate (MIFOR) were used as benchmarks.


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