Forward Rate Agreements (FRAs)

Use

You can use forward rate agreements to specify a fixed interest rate today for a period in the future.

Buyers of FRAs cover themselves against rising interest rates, while sellers of FRAs cover themselves against falling interest rates.

Example:

In 6 months time you will receive 1 million euros, which you want to invest as 3-month money. Since you are currently expecting the interest rates to fall, you arrange a FRA for 1 million euros with your bank today with a starting date in 6 months for a term of 3 months. The agreed interest rate is 5%.

If, for example, the reference interest rate on the fixing date is 4.5%, the bank has to make a settlement payment to you. If the interest rate on the fixing date is above the agreed interest rate of 5%, you have to pay the difference.

Features

  • On the day the interest rate is fixed, the system calculates the settlement payment automatically on the basis of the difference between the agreed interest rate and the reference interest rate. This amount is displayed as an incoming or outgoing payment in the cash flow.

  • When you define the product type in Customizing, you can create a discount FRA as well as the standard FRA. The two FRAs differ in the way in which the settlement payment is calculated.

Calculating the settlement payment for the s tandard FRA:

  • The reference interest rate is fixed on the fixing date

  • The interest amount is calculated automatically on the basis of the difference between the FRA rate and the reference interest rate

  • The interest amount is discounted automatically using the reference interest rate at the start of the hedge period

  • The settlement payment is displayed as the incoming or outgoing payment in the cash flow.

Calculating the settlement payment for the discount FRA:

  • The reference interest rate is fixed on the fixing date

  • The interest amount is calculated automatically both on the basis of the FRA rate and the reference interest rate

  • The interest amount is discounted automatically at the start of the hedge period each time with the interest rate used for calculating the interest amount

  • The settlement payment is calculated as the difference between the discount amounts and displayed as an incoming or outgoing payment.

Activities

  1. On the initial screen, enter the following basic data for the transaction:

  • Company code

  • Product type

  • Transaction type

  • Current transaction activity (order or contract)

  • Business partner

  1. Choose Enter to go to the basic data screen for the transaction. On the Structure tab page, enter the actual transaction data for the FRA.

  1. Enter transaction data in the fields described below: The values in parentheses relate to the example given above.

a. Term area:

  • Start of lead time (0 - today)

  • Start of hedge period (++6)

  • End of hedge period (++9)

b. Interest structure area:

  • Base amount (1m euro = 1,000,000.00 euro)

  • Interest rate (5.0 - the interest rate reflects the forward yield curve)

  • Reference interest rate (LIB_6)

  • Interest calculation method (act/360)

  • Fixing (2-)

èA "6 on 9" FRA has a contract period of 3 months with the start of term in 6 months. At this point in time, the contract is settled and paid out.

c. Business calendar area:

  • Here, you enter the relevant business calendar for moving the date to a working day (such as USA).

  1. You can specify in Customizing whether you want the name of the trader to be displayed automatically. You can also enter additional information, such as the business partner or a reference for the business partner.

  2. You can branch to the entry screens for general transaction management functions. You can use the following tab pages to navigate between the different screens.

Note Note

For more information, see Tab Pages .

End of the note.

  1. To use additional functions, choose Extras and Environment from the menu .

  2. To save the basic data, choose Start of the navigation path FRA Next navigation step Save End of the navigation path .

For more information about options on FRAs, see Interest Rate Guarantee (IRG) .

For general explanations on terms, see Basic Data.