(An excerpt from my MSc dissertation)

A forward contract is a private agreement between two counterparties to buy or sell a particular security or other asset at a particular price at a certain point in the future. The counterparties are usually two banks, or a bank and one of its corporate clients. These two markets are largely separate. Because the deal is private (not traded on a public exchange) the terms, including the delivery date, can be arranged to arbitrary values that are mutually convenient to both parties. The price agreed in the contract is known as the “delivery price”, and it is chosen such that at the moment the contract is entered into, the net value of the contract is zero, therefore parties can enter into forward contracts at no cost until delivery. The “forward price”, if a contract is sold, is the delivery price that would make the contract have a net value of zero. The two are equal at the start of a forward contract, but supply and demand considerations can cause them to diverge over the life of the contract, the forward price varying with the maturity. FX is often traded as a forward.

A forward rate agreement (FRA) is a derivative product, used for locking in interest rates for domestic and FX instruments. It is an agreement that a particular interest rate will apply for a particular duration, on a deposit or loan taken at some time in the future. The reason that the FRA exists is that banks wish to hedge risk, but at the same time make efficient use of their balance sheets in order to remain within their capital adequacy ratio. This is a “forward/forward” deal for a specified sum on a specified day for a specified period, and could be hedged by the bank borrowing at the prevailing rate of the day and depositing the money until it is required. To “hedge” a deal means using a future or options contract to offset the risk associated with an adverse movement in the price of an asset. The cost of the FRA would then be a function of the bank’s cost of borrowing (likely to be less than the cost of the counterparty borrowing, due to credit rating), which will vary for longer or shorter periods, and the interest earned by the bank between the time the FRA is entered into, and the time the contract commences. The necessity of borrowing would reduce the line of credit the bank had with other banks, limiting its own ability to offer credit.

The “forward/forward” technique was used as recently as the 1980s, after which time the FRA was more common. An FRA is concerned with future interest rates, not principal. If the interest rate agreed in the FRA differs from the interest rate offered by the market on that instrument for that tenor, at the time that the FRA becomes active, then one party pays or receives a cash flow equivalent to the difference. This is called “accounting for differences” and carries a lower credit risk than actually having to deliver the principal, which can then be sourced elsewhere. If the interest rates are the same, then no action is taken under the terms of the contract. If the interest rate offered by the market is lower, and the FRA is on a loan, the borrower will have to pay the difference, but will be able to take out a loan at a cheaper rate elsewhere. If the interest rate is higher, then the payment from the lender under the terms of the FRA will help offset the cost of taking a loan at the market rate, if this is necessary. It is also possible to buy an option on an FRA, which will only be exercised if the market moves against the option holder, if the interest rates are expected to change but the direction is uncertain.

The FRA is sold with a bid/offer spread, like other derivative or security product, and it is from the spread that the bank makes its profit on the deal. The FRA market is very competitive; with spreads as low as four basis points (0.04%) therefore the business has great need of technology to maximize efficiency. An FRA can only hedge interest rate risk for a given time, generally between 3 and 12 months, but that risk can be hedged over longer periods using an Interest Rate Swap.


  • Introduction to Futures and Options, John Hull, Prentice Hall 1995

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