Forward Rate Agreement in Interest Rate Risk Management
One of important topics in ACCA Advanced Financial Management is interest rate risk management. During the normal course of the business, it can be seen that there are numerous issues that need to be factored in order to ensure that the overall risk profile is factored in, so that the risk profile is mitigated to a maximized extent.
Risk Management is an important aspect within an organization because it tends to impact the underlying profitability of the company, in addition to the fact that excessive risk exposure can result in companies being unable to sustain themselves in the increasingly competitive marketing landscape.
Interest Rate Risk tends to be one of the most important risk management strategies that needs to be overtaken in order to hedge against potential losses. As a matter of fact, it can be seen that interest rate risk can be defined as the uncertainty that is associated with the unprecedented fluctuation in prices of bonds, or a given investment portfolio. This mainly occurs as a result of increase in market interest rates, happening because of the underlying fear of inflation.
What is a Forward Rate Agreement?
Forward Rate Agreements can be defined as over-the-counter contracts, that take place between parties and determine the rate of interest that needs to be paid on an agreed upon date in the near future. In this regard, it can further be seen that the notional amount is not primarily exchanged.
On the other hand, a cash amount is based on the rate differentials as well as the notional value of the contract. The borrower in this case mostly wants to fix the underlying borrowing costs by entering into a stated Forward Rate Agreement.
Forward Rate Agreement is different from a forward contract. As a matter of fact, it can be seen that Forward Rate Agreements are used to be used along with termination dates, as well as notional value. They are cash-settled, and the payment is based on the net difference between the interest rate of the contract, as well as the floating rate in the market, also referred to as the reference rate.
How does Forward Rate Agreement work?
Forward Rate Agreement comprises of two parties that typically involve parties exchanging a fixed interest rate as opposed to a variable one. In this regard, the party that pays the interest rate for a variable one. The party that pays the fixed interest rate is referred to as the borrower, whereas the party that receives the variable rate can be referred to as the lender. The agreement can highly vary in rate, but the general maturity timeline is that of five years.
From the perspective of the borrower, it can be seen that they enter into a forward rate agreement with the objective of locking in the given interest rate if the borrower believes that rates might increase in the future.
Alternatively, it can also be seen that the borrower mostly wants to fix the borrowing costs in the present run, by entering into a Forward Rate Agreement. In this regard, the spread between the Forward Rate Agreement and the reference rate or floating rate that can be settled on the settlement date or the value date.
The risk to the borrower in this case should also be accounted for, especially in the case where they had to unwind the Forward Rate Agreement and the rate in the market had moved in a negative direction. Forward Rate Agreements can be regarded as liquid instruments that can be unwound in the respective financial market. However, there is a cash difference that is settled between the Forward Rate Agreement Rate and the existing prevalent rate in the market.
Example of FRA in managing interest rate risk
The following scenario illustrates how Forward Rate Agreements work, and can be utilized by the company.
Company Alpha enters into a Forward Rate Agreement with Company Beta. The main covenants involve Company Alpha receiving a fixed rate of 5 per cent on the underlying principal amount across the span of one year. On the contrary, Company Beta is meant to receive the one-year LIBOR Rate, which is determined after a period of three years, tied with the principal amount. The agreement is supposed to be settled in cash at the beginning of the forward period, and is simply discounted by the respective amount that comprises of the contract rate as well as the contract period.
The Forward Rate Agreement payment calculation comprises of calculating the respective amounts based on 5 main principles, which are as follows:
Forward Rate Agreement,
Period (number of days in the contract period), and
Y (number of days in the year based on the respective correct day-count convention of the contract.
Using these parameters, the payment is calculated using the following formula:
Another important aspect within Forward Rate Agreement is the respective calculation of the settlement amounts. This is referred to as the payment that needs to be exchanged on the settlement date. This amount is calculated using two main steps which are as follows:
I. Calculation of the Interest Differential
The interest differential amount, is the underlying result of comparison drawn between the Forward Rate Agreement Rate, and the Settlement Date. It is calculated using the following formula:
II. Calculation of the Settlement Amount
The settlement amount in the Forward Rate Agreement is paid up front. In order to account for respective changes in the prevalent interest rates of LIBOR, interest differential needs to be accounted for. Therefore, the settlement amount is calculated using the present value of the interest differential.
In the case where settlement rate is higher than the contract rate, FRA Seller needs to pay the amount to the buyer. In the case where contract rate is higher than the settlement rate, it tends to be the responsibility of the FRA Buyer to pay the settlement amount to the seller.
If you find this article is helpful and you want to help others too, just share it in any social media (such as Facebook, LinkedIn).