Accounting for Investments, Volume 2: Fixed Income Securities and Interest Rate Derivatives—A Practitioner's Guide

TYPES OF INTEREST RATE DERIVATIVES

Forward rate agreements

A forward rate agreement (FRA) is a contract between two parties to exchange interest payments on a specified notional principal amount for one future period of predetermined length (i.e., one month forward for three months). Effectively, an FRA is a short-term, single-period interest rate swap. Only interest flows are exchanged and no principal is exchanged. In a generic FRA one party pays fixed and the other party pays floating. This exchange allows for conversion of variable rate funding to fixed rate exposure or fixed rate funding to variable rate exposure.

Settlement: Settlement of an FRA is on a net basis and can occur on the start date or the maturity date. If the FRA is settled on the start date, the settlement is on a present value basis. If the FRA is settled on the maturity date, the settlement is on a same day basis. The settlement reflects the difference between the FRA rate and the floating rate set for the period. The determination of the floating rate depends upon its underlying index (i.e., LIBOR, Commercial Paper, Prime, etc.).

Normally there is a buyer and a seller of an FRA. The buyer is the fixed-rate payer and the seller is the floating rate payer. If interest rates increase, the value of the FRA increases to the buyer. If interest rates decline, the value of the FRA increases to the seller. An FRA can be terminated at any time with the consent of both parties. The termination amount (market value) ...