A forward rate agreement (FRA) is cash-settled forward contracts based on the difference between a fixed rate and a floating reference rate in force for the period covered in the FRA. If you buy a FRA you are agreeing to pay a fixed rate; if you sell a FRA you are agreeing to receive a fixed rate.
The terminology used might appear as a ‘3 x 6 FRAÕ meaning an agreement to pay/receive a fixed rate of interest starting in 3 months’ time and ending in 6 months’ time (therefore for a 3 month period).
Step 1
Calculate the difference in interest rates. In this example the company receives 4.5% and pays 5.0%. The annual difference is a 0.5% loss.
Step 2
Pro-rate the difference for the length of the contract -0.005 x 180/360 = -0.0025
Step 3
Apply the pro-rated difference in interest rates to the notional value of the contract. -0.0025 x $1,000,000 = -$2,500
Step 4
Discount the cash flow back to the expiration date. The payoff occurs at the expiration date therefore need to be discounted at LIBOR for six months. -$2,500 / 1.025 = $2,439
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