CFA Level I Derivatives – Forward Rate Agreement

This is an excerpt from our comprehensive animation library for CFA Level I candidates. For more materials to help you ace the CFA Level I Exam, head on down to

A forward rate agreement or fr ray and short is a derivative contract that has a future interest rate as its underlying libor is most often used as the underlying rate u.s. dollar libor refers to the rates on euro dollar time deposits interbank u.s. dollar loans in london the point of entering into an fr ray is to lock in a certain interest rate for borrowing or

Lending at some future date for example green is a borrower and he anticipates that he’ll need to take a 100 thousand 90-day loan 30 days from now the current market rate that he can borrow at is 90 day libor rate of 3 percent and he’s concerned that the libor would have risen by the time he actually takes the loan what he can do is to take the loan long side of

A forward rate agreement with a notional principal of $100,000 by entering this contract he agrees to be the fixed rate payer in return he receives floating rate payments from the short the short can be a lender or investor who has a sum to lend in the future and wants to lock in the current interest rate so for example red anticipates that he’ll receive $100,000

In 30 days and is concerned that the interest rate may fall in the next 30 days he locks in the current rate by taking the short position against green by entering the fr a changes in the future rate will not affect him as the short red has to pay green the floating rate at expiration of the contract so green and red enter into a 30 day forward rate agreement with

A current 1 year libor of 3 percent as the reference rate on a notional value of $100,000 as with forward contracts no payment is made at initiation the payment is only made at settlement fr a are usually cash settled with the payment based on the net difference between the spot interest rate and the reference rate in the contract so as in this case since the

Long has to pay the short to a higher rate the net difference in rate on the notional principal is paid from the long to the short the calculation of the actual amount to pay shall be left to the level to curriculum after settlement green party can take a one hundred thousand dollar loan at the current libor rate as he has intended note that even though he takes

The loan at 2.7 percent libor rate when we take into account the net cash amount paid to the short the effective interest rate that he paid is closer to the three percent reference rate so the long has lost out for entering the fr a in this case the red party can also lend to the one hundred thousand that it now has at the libor rate for him even though the rate

That he lands at is 2.7 percent when we take into account the net amount that he receives from the long the effect of interest that he receives is closer to the reference rate of 3 percent so the short in this case has benefited for entering the fr a note that the fr a contract only applies from its initiation to the settlement date what either party does after

Settlement is not within the terms of the contract you’re watching an excerpt from our comprehensive and animation library for more videos like these head on down to prep nuggets comm earth prep nuggets let us do the hard work for you

Transcribed from video
CFA Level I Derivatives – Forward Rate Agreement By PrepNuggets