Since the terminal (maturity) value of a forward position depends on the spot price that will prevail then, this contract can be considered “a bet on the future spot price” from a purely financial point of view. [3] A borrower could enter into a forward rate agreement to set an interest rate if they believe interest rates could rise in the future. In other words, a borrower may want to set their borrowing costs today by entering a FRA. The cash difference between the FRA and the reference interest rate or the variable interest rate shall be settled on the value date or settlement date. where N {displaystyle N} is the nominal value of the contract, R {displaystyle R} is the fixed interest rate, r {displaystyle r} is the published -IBOR fixing rate, and d {displaystyle d} is the fraction of the decimalized daily counter over which the start and end dates of the value of the -IBOR rate extend. For USD and EUR, this follows an ACT/360 convention and GBP follows an ACT/365 convention. The cash amount is paid on the start date of the value applicable to the interest rate index (depending on the currency in which the FRA is traded, this is done immediately after or within two working days of the published IBOR fixing rate). The market opinion on the spot price of an asset in the future is the expected future spot price. [1] A central question is therefore whether the current forward price actually predicts the respective spot price in the future or not.
There are a number of different assumptions that attempt to explain the relationship between the current futures price F 0 {displaystyle F_{0}} and the expected future spot price E ( S T ) {displaystyle E(S_{T})}. A forward rate contract is different from a futures contract. An exchange date is a binding contract in the foreign exchange market that sets the exchange rate for buying or selling a currency on a future date. A currency date is a hedging tool that does not require an upfront payment. The other major advantage of a currency futures contract is that, unlike standardized currency futures, it can be tailored to a specific amount and delivery period. The nominal amount of $5 million will not be exchanged. Instead, the two companies involved in this transaction use this number to calculate the interest rate differential. A forward settlement in foreign currency can be made in cash or delivery, provided that the option is acceptable to both parties and has been previously specified in the contract. Forward rate contracts (FRAs) are over-the-counter contracts between parties that determine the interest rate to be paid at an agreed time in the future. A FRA is an agreement to exchange an interest obligation for a nominal amount.
where {displaystyle r} is the continuously compounded risk-free return and T is the maturity period. The intuition behind this result is that if you want to own the asset at time T, in a perfect capital market, there should be no difference between buying the asset today and holding the asset and buying the futures contract and receiving the delivery. Therefore, both approaches must cost the same price in terms of present value. For evidence of arbitration as to why this is the case, see Rational Pricing below. The value of a term position at maturity depends on the relationship between the delivery price ( K {displaystyle K} ) and the underlying price ( S T {displaystyle S_{T}} ) at that time. In finance, a forward rate contract (FRA) is an interest rate derivative (IRD). In particular, it is a linear IRD with strong associations with interest rate swaps (IRS). Suppose that F V T ( X ) {displaystyle FV_{T}(X)} is the fair value of cash flow X at the expiry date of contract T {displaystyle T}. The forward price is then indicated by the formula: the present value of the differentiated amounts on a FRA exchanged between the two parties and calculated from the point of view of the sale of a FRA (which mimics the receipt of the fixed interest rate) is calculated as follows:[1] FRA are not loans and do not constitute agreements to lend a sum of money to another party on an unsecured basis. at a pre-agreed rate. Its nature as an IRD product only creates leverage and the ability to speculate or hedge interest rate risks.
Not having initial cash flow is one of the advantages of a futures contract over its futures counterpart. Especially if the futures contract is denominated in a foreign currency, cash flow management simplifies because there is no need to post (or receive) daily settlements. [9] The ratio between the spot and forward rates of an asset reflects the net cost of holding (or carrying forward) that asset relative to holding the lease capital. Thus, all the above costs and benefits can be summarized as the cost of transportation, c {displaystyle c}. Therefore, the FRA determines the tariffs to be used as well as the date of termination and the nominal value. FRA are settled in cash with the payment based on the net difference between the contract interest rate and the market variable interest rate, called the reference rate. The nominal amount is not exchanged, but a cash amount based on exchange rate differences and the nominal value of the contract. .