Forward Rate Agreement - CA Final SFM

Forward Rate Agreement is an OTC (Over the Counter) derivative in which banks act as an market makers and provide bid and ask quotations.

Understanding Quotations

6 x 9 FRA at 9 % / 13 %

This means bank is ready to do contract on (9 % bid rate and 13 % ask rate) after 6 months for 3 months.

Buying FRA = Contract to borrow

Selling FRA = Contract to Invest

Calculation of Interest Rate

If R = Rate for Longer Period

If r₁ = Rate for Shorter Period₁

If r₂ = Rate for Shorter Period₂

Then,

(1 + R) = (1 + r₁) x (1 + r₂)   

If Interest Rate as per above calculation is not equal to the rate quoted by bank then there will be arbitrage profit.

Borrow at Lower Rate.

Invest at Higher Rate.

Arbitrage Process

I. Borrow at zero period either short or long period depending upon rate quoted by bank and Theoretical Interest Rate.

If Rate quoted by bank for shorter period is less than theoretical interest rate (Interest Rate as per calculation) then,

Borrow for first shorter period and enter into forward rate agreement for second shorter period to borrow money and invest money for longer period.

If Rate quoted by bank for shorter period is more than theoretical interest rate (Interest Rate as per calculation) then,

Borrow for Longer period and Invest Money for first shorter period and enter in to forward rate to invest for second shorter period.

II. Execute forward contract after completion of first shorter period.

III. Realize Investment after completion of full period and pay loan.

IV. Arbitrage Profit = Investment Realized – Loan Repaid.    

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