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Forward Rate Agreement

hsuwang

Member
Hello David,
For the FRA, the lender receives a fixed rate while paying a floating rate (LIBOR), however, is the principle actually being exchanged, that is, does the borrower of the principle actually borrows the money from the lender on time T1, or is FRA just a contract where 2 parties are "betting on the interest rate movement" and seek to make a profit on the rate difference.
The reason I ask this is because in Hull's text, he only talks about (or emphasizes) on the cash flow due to the difference between the contracted fixed rate (Rk) and floating LIBOR (Rm), but he does not talk about the cash flow from the fixed interest made on the principle (ie.4% fixed interest on the principle).

Thanks.
 

David Harper CFA FRM

David Harper CFA FRM
Staff member
Subscriber
Hi Jack,

No, the principal in an FRA is not exchanged. When recording the tutorial, I think I briefly noted that I was confused by Hull's use of the term "principal" here! And I remain unsure why he does not use "notional" here...

As I check my trusted Neftci Principles of Financial Engineering, I see that Neftci indeed refers to an FRA notional and even has a footnote saying "The N represents notional principal since the principal amount will never be exchanged." Note Neftci uses "notional principal;" but I think it is cleaner to refer to principal (i.e., funded) or notional (merely referenced).

So, in short, the FRA is nearer to your notion of "betting on the interest rate" since one counterparty will be paying the other based on the difference between the contracted rate (Rk) and the observed LIBOR (Rm). It's not like full-on borrowing but rather like the "netting" in a swap (and like the i rate swap where notional is referenced, principal is not exchanged).

Finally, note that to determine the net cash flow, Hull only requires the two rates (Rk and Rm), the third rate is the forward rate (Rf) which is not needed in Example 4.3.. The forward rate (Rf) is used only for the valuation of the FRA subsequent to inception.

David
 
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