CFA CFA Level 2 Understanding and valuing FRAs

# Understanding and valuing FRAs

• Author
Posts
• 13

I don’t know about you guys, but I tend to have a mental seizure when I look at forward rate agreements.

I get the notation: e.g. a 2×3 FRA means a 30 day loan in 60 days. Right.
However, I then read that for the same 2×3 FRA, 40 days after initiation means that there are 20 days remaining until the FRA expires.

Shouldn’t it be 20 days after the FRA initiates, and 50 days after the FRA expires?

Also, can anyone walk share their thought process on how to value FRAs? I’m trying to fight my way out of the jargon filled explanations given. I’ve a feeling it’s not hard to get, once I ‘get it’…

Thanks guys! Hope revision is going well.

• 4

@fabian I think you’re thinking that the agreement starts at 20 days, and ends at 50 days. Instead, the FRA has already started 40 days ago, will expire in 20 days (and the loan starts), and the loan with will end in 50 days. That’s why there is always 3 relevant dates in an FRA agreement. @diya is spot on here.

• 3

@diya @reena @christine ah got it – that makes sense now. Many thanks for the help!

Any thoughts on how to logically think about pricing FRAs?

• 1

@fabian tricky question. I simply detest the FRA notation…

2×3 FRA

2 – the FRA will mature/expire in 2 months
3 – the underlying loan will mature in 3 months
1 – the difference is the duration of the loan. Or in other words the 30-day LIBOR rate 60 days from now.

40 days after the initiation of the contract means:

the 2 (which is 60 days in terms) only has 20 days (60-20) lefts before the contract (FRA) should expire.

How did you get, “Shouldn’t it be 20 days after the FRA initiates, and 50 days after the FRA expires”?

Think of it this way, if you have a long position in an FRA agreement means you have the obligation to borrow money in 60 days. But you aren’t borrowing at the initiation of the FRA contract, you are going to borrow for 30 days in 60 days time.

The value of the contract is derived from the difference in the floating and fixed rate (or the price of the FRA agreement).

At the date of expiration of the FRA agreement if the floating rate is above the rate specified in the forward agreement you basically have the right to borrow at below market rates. (Which makes you happy and you receive payment from the short position and treat yourself to a nice Armani suit with a French cut dress shirt).

I hope I’m right….

• Reena
Participant
• CFA Charterholder
1

@diya’s spot on.

@fabian
, I don’t get how you arrived at “Shouldn’t it be 20 days after the FRA initiates, and 50 days after the FRA expires” too?