What is a FRA?What is the formula for making payments in a FRA?
Consider a FRA that Expires/settles in 30 days. Bzased on notional principal of 1 million and is based on a 90 DAY LIBOR. Specifies a forward rate of 5%. Actual 90 Day LIBOR at expiration (30 days from now is 6%. compute cash settlement at expiration.
A FRA is a forward contract to borrow/lend money at a certain day in the future. A long in a FRA means you are borrowing money at a certain rate in the future. A short in a FRA means you are lending money at a certain rate in the future. If interest rates go up, a long makes money bc the rate at which you agrred to borrow is lower than the current rates.
Formula is 2 parts First: (notional Principal)*(Floating-forward)*(Days/360). This gets the interest amount gained if you could borrow at the day of the settlement date. However, typically you get paid until the end of the denominated loan period. Therefore you must divide this interest rate by 1+(.06)(Days/360)
Answer to Question : (.06-.05)*(90/360)*1 Million = 2,500$. This 2500 in interest savings would not come until end of 90 Day Loan period. Value at settlement is the present value of these savings. Use the discount rate of actual rate at settlement, not the contract rate of 5%.
2,500/1+(.06*(90/360))= 2463.05 which is what the short would pay the long and is the present value of the savingns at settlemtn.
On the equation, if floating rate happens to be less than the forward rate, the number is negative meaning the logn would pay. This hapens bc the current rate is less than the contract rate, and you lose money bc you could technically borrow at a lower rate with current rates than you can in the contract.