Forward Rate Agreements (Definition and Hedging)

CA FINA SFM
BATCHES FOR NOV

14 AND MAY 15
TO COMMEMCE IN
AUGUST (EVE)
AND SEPT
(MORNING)
SFM by CA PRAVINN MAHAJAN
Ph
9871 255 244
Besides teaching since 1999 CA PRAVINN MAHAJAN has wide

experience in fields of SEZ consultancy, Taxation , Project Finance
He is actively trading in Stock market since 1995 (since teenage),
being a descendant of family of traders. He has extensively
researched Scams in stock Market and financial institutions over a
period of 20 years, starting from 1992 Harshad Mehta Stock Scam.
CHECK SCAMS AT END OF THIS MODULE
He has witnessed the advent of derivative trading since 2001 and
engaged in derivative (commodity and stock) trading since and
also took advantage from the new ventures commenced in form
of currency trading in 2008.
Due to his wast experience, study and understanding of Markets,
he has acquired indepth knowledge of various aspects and
concepts of Financial Management which is recognised by various
Business Administration Institutes and Training divisions of Banks
and Financial Institutions where he shared his Knowledge as guest
faculty. He delivered lectures on Scams in Indian markets
He is widely acknowledged and appreciated for his simplistic and story oriented delivery of
Complicated Concepts in the field of Finance, Prerfect illustration of which is given in this module,
in which discussion is made about realtively new concept in the field of Finance FORWARD RATE
AGREEMENTS which he also delivered in various organisaions.
He is known for adopting formula free approach for understanding and imparting such
understanding on various aspects of finance.
He has been a faculty exclusively for CA Since 2001 and is teaching MAFA / SFM since 2008. He has
designed various shortcuts in respect complicated topics like Money market hedge, Forward rate
interest, Bond duration besides others. 7 years experience in the similar subject has enabled to
understand the requirements of students and corrobrate and match it with the changing demands
and patterns of CA Examination and standards of ICAI
His BELIEVINGS
TEACHING, BESIDES AN ABILITY IS AN ART. TEACHING BECOMES FUN, WHEN INSTRUCTOR
THROUGH HIS INSTRUCTIONS INDUCES THE CONCEPTUAL LEVEL OF PUPIL TO MATCH HIS LEVEL
AND THEN INVITE INNOVATIVE QUERRIES FROM FRESH PERSPECTIVE ORIENTED MIND OF PUPILS
LEARNING IS A NEVER ENDING PROCESS, SOMETIMES STUDENTS RENDERS NEW PERSPECTIVE TO
ANY CONCEPTS AND DISCUSSIONS
CLOSED AND BLOCKED MIND IS A SOCIAL AND ECONOMIC WASTE. ONE SHOULD KEEP HIS MIND
OPEN TO NEW PERSPECTIVES AND OPPORTUNITIES
ATTITUDE OF ANGER AND ARROGANCE DOES NOT GEL WITH OUR PROFESSION. PEOPLE SKILLS
MATTERS
CHECK VIDEO OF FORWARD RATE INTEREST on Facebook page Pravinn Mahajan Classes
Or Youtube link https://www.youtube.com/watch?v=yJIivLL6fCc&feature=youtu.be
Ph
9871 255 244
A Forward Rate Agreement, or FRA, is an agreement between two
parties
who want to protect themselves against future movements in

interest rates.
By entering into an FRA, the parties lock in

an interest rate for a stated period of time
starting on a future settlement date, based
on a specified notional principal amount.
The BUYER of the FRA enters into the

contract to protect itself from a future
increase in interest rates. This occurs when a
company believes that interest rates may rise
and wants to fix its borrowing cost today.
Ph
9871 255 244
The SELLER of the FRA wants to protect itself

from a future decline in interest rates. This strategy
is used by investors who want to hedge the return
obtained on a future deposit.
FRAs are settled using cash on the settlement
date. This is the start date of the notional loan or
deposit. The exposure to each counterparty is determined by the interest
rate differential between the market rate on settlement date and the rate
specified in the FRA contract. There are no principal flows.
Payment and gain or loss is
made and ascertained on
Settlement date
_____________________________________________________________________
Agreement date
STATED PERIOD OF TIME
Settlement date
Maturity date
SETTLEMENT PERIOD
The FRA is a very flexible instrument and can
be tailored to meet the needs of both the
buyer and seller to protect themselves against
the volatility of interest rates which affect their
future borrowings or investments.
1.
2.
Forward Rate Agreements can be used for

Hedgeing - Hedging through FRAs enables the prospective Borrower
or Depositor to Cover the risk arising due to fluctuation in Interest Rates
Arbitrage Arbitrage in FRAs enables speculators to make profits

due to flutuation in Interest rates. FRA Arbitrage requires understanding of
PRICING OF FRAs and FORWARD
RATE INTEREST
Ph
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HEDGING THROUGH FRAs

WHY THE NEED FOR HEDGING THROUGH FRA
ARISE AND WHO ARE THE PARTIES INVOLVED
Mr. X
-________________________ ______________________________________
TODAY
Date on
3 Months
6 MONTHS
Which loan is
Needed
PERIOD FOR WHICH LOAN

IS NEEDED
Mr. X will Borrow 1,00,000 after 3
Bank A
months from
2.
Ph
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BANK A IS currently charging

rate of interest of M + 2%.
AND CURRENT MIBOR IS 8%

PROBLEM OF X
X EXPECTS THAT MIBOR WILL INCREASE AFTER 3
MONTHS TO 9.75%, THEREBY INCREASING TOTAL
RATE OF INTEREST TO (9.75 + 2%) = 11.75%
X DOES NOT WANT TO PAY RATE OF INTEREST
MORE THAN 11% I.e X NEEDS MIBOR OF 9%
INTRODUCING BANK B
BANK B will come to the rescue of X
Ph
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NOTE - There are 3 parties to understand mechanism of hedge through forward rate
agreement
(1) Mr. X
(2) Bank A (3) Bank B
Mr. X will deal with bank A and Bank B
There will be no dealing or connection or transaction between Bank A
and Bank B
X will make a transaction with Bank A in delivery Market i.e X will take
actual loan or delivery of funds from Bank A after 3 months and will
repay such loan with interest after 6 months from date of Loan
X will make transaction with Bank B in future or Forward market
Whether FRA TO BE BOUGHT OR SOLD
DELIVERY
MARKET
X will actually take
delivery of funds as a loan
from Bank A on this date
BANK A
_______________________________________________________________________________
Today
FUTURE
OR
FORWARD
MARKET
3 Months
6 Months
WHAT TRANSACTION WILL

. X MAKE WITH BANK B
In FUTURE MKT.
?
BANK B
Ph
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Points To be kept in mind for hedging
Two Markets are needed for hedging. In this case

(1) Spot or delivery market from where loan is taken
(2) Forward or Future Mkt. From which hedge is made
If One action (purchase) is taken in one market then opposite action
(Sale) is to be taken in another market
If entry is taken in one market by making a transaction (purchase),
then exit from such market can be taken by making opposite
transaction (sale)
DELIVERY
MARKET
1
2
X will take a loan

of Rs 1,00,000 from
Bank A on this date
---------------------------------i.e X Bought Money
.
.
Bank A
__________________________________________
Today - Entry date for FRA
3 MonthsExit date for FRA
FUTURE
OR
X will Sell FRA
X will
5
FORWARD
to
Bank
B in future
Buy FRA
Market on this date
MARKET
today From
Bank B
On closing date i.e on exit date FRA is SOLD to bank B in

Future Mkt, this implies on entry date i.e today, opposite
action must hv been take in future Mkt.
Thus today FRA is bought from Bank B in future Market
Since purchase
money action is
taken in delivery
market,
So opposite
action is to be
taken in Future
market
X will sell
money on this
date in Future
Market i.e he
will sell FRA on
this date
Since
X has to Borrow money after 3 Months So he will
buy FRA today (If X Has to Invest Money after 3 Months he will sell FRA today)
Ph
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MECHANISM OF FRA
has to Borrow 1,00,000 after 3 months for 6 months

X will Buy FRA today from Bank B in Future Mkt (meaning & significance of buying FRA
explained in process and verification)
He will Borrow From Bank A in delivery market after 3 months

He will sell FRA in Future Market to Bank B after 3 months
This procedure ensures
will pay his desired rate of interest irrespective of rate
of Interest in delivery Market I.e whether rate of interest of Bank A increases or
decreases after 3 months, Interest expense of
EIGHT
will be his desired rate
DENOMINATION OF FRA
X will borrow money after 3 months for 6 months and he will hedge the
borrowing transaction by buying FRA. This FRA is denominated as 3 x 9 FRA or 3/9 FRA
9 Months
__________________________________________________________
3 Months
6 Months
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HOW FRA ENSURES THAT

Xs Interest Expense will be his desired rate ,
whether actual rate of interest in delivery market increases or decreases.
(Process and Verification)
CURRENT RATE OF INTEREST OF BANK A IS M+2% and CURRENT M IS 8%, i.e effective
rate of Interest is 10%
X does not want to pay more than 11%
CASE 1
RATE OF INTEREST INCREASES

M IN MARKET AFTER 3 MONTHS (i.e ON DATE OF LOAN IS 9.75%)
Rate of Interest On date of loan is 11.75%
Assumption
- rate of FRA in Future Mkt = Actual rate of Interst applicable in Market (if
nothing else given)
- Current rate of FRA offered by bANK B today is M+ 2 % and Bank B is Offering
M at 9%
DELIVERY
MARKET
Actual ROI is M+ 2 %
and Actual M is 9.75%
= 11.75%
Actual ROI is M+
2 % and M is 8%
= 10%
_________________________________
Today
3 months
FUTURE OR
FORWARD
MARKET
Rate of FRA
offered by Bank
B is M+2 % and
M is 9% i.e 11%
Since Rate of FRA in Future Mkt

Not given, so rate of FRA =
Actual Rate of Interest
i.e Rate of FRA is 9.75 + 2 =
11.75%
10
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X will buy FRA today from Bank B @ 9 + 2 = 11%
Meaning of Buying FRA
Practically FRA is bought
This implies
X made an agreement today to NOTIONALLY borrow
1,00,000 from Bank B after 3 months at current rate of FRA i.e 9+ 2% = 11%
But after 3 months actual rate if 9.75 + 2% = 11.75% , thus

benificial position
x is in
X will Sell FRA after 3 months to Bank B at 11.75%, thus providing a

gain of 0.75% to
X. This gain is paid to
X by Bank B after 3
months i.e on the date he will take loan from Bank A
After 3 months
X will actually borrow 1,00,000 from Bank A at 11.75%
On this date i.e on date of loan

X will sell FRA to bank B at 11.75% . Thus
gain to X is 0.75% which Bank B will pay to X on this date
Thus cost to
X is
Payable to Bank A
(after 6 months from date of loan)
Gain recievable from bank B
Net Interest cost to
=
=
11.75%
0.75%
11.00%
Amount of gain receivable from Bank B

( Difference between M on date of

Notional
12
SELLING FRA & BUYING FRA)
X Principal X
___________________________________________________________
1
Actual MiBor
On date of Loan
( .% % ) ,,
+ .
11

12
358
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.
LOGIC OF AMOUNT OF GAIN PAYABLE BY BANK B TO
Amount of Interest is to be paid by
payable by Bank B to
X to Bank A after 6 months from date of loan. Gain
X is in the nature of compensation for additional interest payable by
X to Bank A. Since this additional interest is payable after 6 months from date of loan, and
comensation is payable by bank B to
X on date of loan, So bank B will pay present value
such additional interest
Verification of Interest Cost to
Loan Required by X from bank A
1,00,000
Compensation recd from Bank B
358
Net loan to be taken from bank A
99,642
Amount payable to Bank A after 6 months
(1 + .1175/2)99642
= 1,05,496
Effective rate of interest to =
( 1,05,496 1,00,000 )
1,00,000
12
6
= 10.99 or 11%
Thus Due to FRA Interest cost to X is 11%, although actual market rate on interest is
11.75%
12
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CASE 2
RATE OF INTEREST DECREASES

M IN MARKET AFTER 3 MONTHS (i.e ON DATE OF LOAN IS 7.90 %)
Though actual rate of interest is reduced, but due to FRA hedge Effective
cost of Interest to X will be 11%.
DELIVERY
MARKET
= 9.90%
Actual ROI is M+
2 % and M is 8%
= 10%
_____________________________________
Today
FUTURE OR
FORWARD
MARKET
3 Months Date of loan
Rate of FRA
offered by Bank
B is M+2 % and
M is 9% i.e 11%

9.90%
X will buy FRA today from Bank B @ 9 + 2 = 11%
After 3 months
X will actually borrow 1,00,000 from Bank A at 9.90%

to
X will sell FRA to bank B at 9.90% . Thus loss
X is 1.10% which Bank B will pay to
Thus cost to
X on this date
X is
Payable to Bank A
(after 6 months from date of loan)
Loss payable to bank B
Net Interest cost to
13
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=
=
9.90%
1.10%
11.00%
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Amount of Loss payable to Bank B


Notional
12
X Principal X
___________________________________________________________
1
Actual MiBor
On date of Loan
( .% % ) ,,
Verification of Interest Cost to

12
529
Loan Required by X from bank A
1,00,000
Amount Payable to Bank B
529
Total loan to be taken from bank A
1,00,529
Amount payable to Bank A after 6 months
(1 + .0990/2)1,00,529
= 1,05,505
Effective rate of interest to X =
( 1,05,505 1,00,000 )
1,00,000
12
6
= 11.01 or 11%
14
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Above senario explained the procedure to Use FRA hedge in the situation when
X needs to borrow funds after 3 months for 6 months
What if X Have surplus or Idle funds after 3 months for a period of 6 months,
i.e X needs to Invest surplus funds after 3 months for a period of 6 months.
Mr. X
-________________________ ______________________________________
3 Months
Date on
6 MONTHS
TODAY
Which surplus is PERIOD FOR WHICH Investment
Invested
IS to be Made
Mr. X will INVEST 1,00,000 after 3 months

With
Bank A
15
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BANK A IS currently GIVING

rate of interest of M + 2%.
AND CURRENT MIBOR IS 8%

PROBLEM OF X
X EXPECTS THAT MIBOR WILL DECREASE AFTER 3
MONTHS TO 6.25%, THEREBY REDUCING TOTAL
RATE OF INTEREST TO (6.25 + 2%) = 8.25%
X WANTS THAT RATE OF INTEREST ON
INVESTMENT SHOULD NOT BE LESS THAN 9% I.e X
NEEDS MIBOR OF 7%
INTRODUCING BANK B
BANK B will come to the rescue of X

.
16
Ph
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Whether FRA TO BE BOUGHT OR SOLD
DELIVERY
MARKET
1
2
X will deposit
1,00,000 in Bank A on
this date
---------------------------------i.e X Sell Money
.
.
Bank A
__________________________________________
Today - Entry date for FRA
3 MonthsExit date for FRA
FUTURE
OR
X will BUY FRA
X will
5
FORWARD
from Bank B in future
SELL FRA
Market on this date
MARKET
today to
Bank B
On closing date i.e on exit date BOUGHT from bank B in

Future Mkt, this implies on entry date i.e today, opposite
action must have been take in future Mkt.
Since Sell
money action is
taken in delivery
market,
So opposite
action is to be
taken in Future
market
X will buy
money on this
date in Future
Market i.e he
will buy FRA on
this date
Thus today FRA is SOLD Bank B in future Market
SINCE
today
X Has to Invest Money after 3 Months he will sell FRA
17
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MECHANISM OF FRA
has to invest 1,00,000 after 3 months for 6 months
X will Sell FRA today from Bank B in Future Mkt
He will Invest in Bank A in delivery market after 3 months
He will BUY FRA in Future Marketfrom Bank B after 3 months
This procedure ensures
will recieve his desired rate of interest irrespective of
rate of Interest in delivery Market I.e whether rate of interest of Bank A decreases
or increases after 3 months, Interest income of
will be his desired rate
HOW FRA ENSURES THAT

Xs Interest INCOME will be his desired rate ,
whether actual rate of interest in delivery market decreases or increases.
(Process and Verification)
CURRENT RATE OF INTEREST OF BANK A IS M+2% and CURRENT M IS 8%, i.e effective
rate of Interest is 10%
X does not want his interest income to be less than 9%
CASE 1
RATE OF INTEREST REDUCES

M IN MARKET AFTER 3 MONTHS (i.e ON DATE OF Investment IS
6.25%)
Rate of Interest On date of investment is 8.25%
Assumption
nothing else given)
M at 7%
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DELIVERY
MARKET
Actual ROI is M+
2 % and M is 8%
= 10%
= 8.25%
_________________________________
Today
3 months
FUTURE OR
FORWARD
MARKET
Rate of FRA
offered by Bank
B is M+2 % and
M is 7% i.e 9%

8.25%
X will sell FRA today to Bank B @ 7 + 2 = 9 %
Meaning of SELLING FRA
Practically FRA is SOLD
This implies
X made an agreement today to NOTIONALLY INVEST
1,00,000 to Bank B after 3 months at current rate of FRA i.e 7+ 2% = 9%
But after 3 months actual rate if 6.25 + 2% = 8.25% , thus

benificial position
x is in
X will buy FRA after 3 months from Bank B at 8.25%, thus providing a
gain of 0.75% to
X. This gain is paid to
X by Bank B after 3
months i.e on the date he will take invest in Bank A
After 3 months
X will actually invest 1,00,000 in Bank A at 8.25%

X will buy FRA from bank B at 8.25% . Thus
gain to X is 0.75% which Bank B will pay to X on this date
19
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Thus Interest income of

X is
Recievable from Bank A
(after 6 months from date of investment)
Gain recievable from bank B
Net Interest Income of
=
=
8.255%
0.75%
11.00%


Notional
12
X Principal X
___________________________________________________________
1
Actual MiBor
On date of
INVESTMENT
+ .
( % .% ) ,,
Verification of Interest Income to

12
364
Investment to be made by X in bank A
1,00,000
Amount recd from Bank B
364
total investment to be made in bank A
1,00,364
Amount recievable from Bank A after 6 months (1 + .0825/2) 1,00,364

= 1,04,504
( 1,04,504 1,00,000 )
Effective rate of interest =
1,00,000
12
6
= 9%
Thus Due to FRA Interest income of X is 9%, although actual market rate on interest is
8.25%
20
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CASE 2
RATE OF INTEREST INCREASES

M IN MARKET AFTER 3 MONTHS (i.e ON DATE OF investment is
8.20%)
Assumption
nothing else given)
M at 7%
DELIVERY
MARKET
Actual ROI is M+
2 % and M is 8%
= 10%
= 10.20%
_________________________________
Today
3 months
FUTURE OR
FORWARD
MARKET
Rate of FRA
offered by Bank
B is M+2 % and
M is 7% i.e 9%

10.20 %
X will sell FRA today to Bank B @ 7 + 2 = 9 %
After 3 months
X will actually invest 1,00,000 in Bank A at 10.20%
On this date i.e on date of investment

X will buy FRA from bank B at 10.20%
Thus loss to X is 1.20% which X will pay to Bank B on this date
21
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Thus Interest income of

X is
Recievable from Bank A
(after 6 months from date of investment)
Loss payable to bank B
Net Interest Income of
=
=
10.20%
1.20%
9.00 %


Notional
12
X Principal X
___________________________________________________________
1
Actual MiBor
On date of
INVESTMENT
( % .% ) ,,
+ .
Verification of Interest Income to

12
576
Investment to be made by X in bank A
1,00,000
Amount payable to Bank B
576
Net investment to be made in bank A
99,424
Amount recievable from Bank A after 6 months (1 + .102/2) 99,424

= 1,04,494
( 1,04,494 1,00,000 )
1,00,000
12
6
= 8.99 or 9%
Thus Due to FRA Interest income of X is 9%, although actual market rate on interest is
10.20%
Pricing of FRA and Arbitrage through FRA in next Module
22
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Eg.
AB Tech plans to borrow $10 million in 30 days at 90-day LIBOR plus 100
basis points. To lock in a borrowing rate of 7 percent, it purchases an FRA at a
rate of 6 percent. This contract would be referred to as a 1 x 4 FRA because it
expires in one month (30 days) and the underlying Eurodollar matures four
months (120 days) from now. Thirty days later, LIBOR is 7.5 percent.
Demonstrate that AB Tech's effective borrowing rate is 7 percent if LIBOR in
30 days is 7.5 percent.
Ans
AB Tech Plans to borrow $ 100 lacs 30 days from today for a period of 90 days
AB plans to borrow at 7%, but on date of borrowing is 7.5 + 1 = 8.5%
AB will borrow 100
lac @ 7.5 +1 =
8.5%. (money buy)
_____________________________________________
Today
1 month
AB will buy money

i.e will buy FRA at
6 + 1 = 7%
3 month
AB will sell money
i.e will sell FRA at
7.5 +1 = 8.5%
Since AB Tech has to borrow after 30 days, so Company will Buy FRA today (but
this is given in question) at 6 + 1 = 7%
Steps
- Company will by FRA today at 7%
- Company will borrow $ 100 lacs at 8.5% after 30 days
- Company will sell FRA on the date of borrowing at 8.5% . Thus gain on FRA 1.5%
Thus cost to AB is
Payable to Bank on loan
(after 3 months from date of loan) =
8.5%
Gain on FRA
=
1.5%
Net Interest cost to AB
7.00%
23
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Amount of gain receivable on FRA

( Difference between L on date of

Notional
12
X Principal X
___________________________________________________________
1
Actual MiBor
On date of Loan
( . % ) ,,
+ .

12
$ 36,809
Statement of Verification
Loan required by AB
Gain on FRA
100,00,000
37,500
Net loan taken
99,62,500
Amount payable after 3 months
99,62,500 ( 1 + 0.085x
= 101,74,203
( 101,74,203 100,00,000 )
100,00,000
12
3
= 6.9%
0r 7%
24
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25
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26
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27
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Check demo video on Fb page Pravinn Mahajan classes
NEW BATCH FOR NOV 14 & MAY 15 TO

COMMENCE IN AUG (EVE) & SEPT (MORNING)
BY
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INCLUDING MODUS OPERANDI ON
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& COMPLETE PAPER IN LESSER TIME WITH
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Forward Rate Agreements (Definition and Hedging)

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Forward Rate Agreements (Definition and Hedging)

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CA FINA SFM

BATCHES FOR NOV

SFM by CA PRAVINN MAHAJAN

9871 255 244

Besides teaching since 1999 CA PRAVINN MAHAJAN has wide

SFM by CA PRAVINN MAHAJAN

9871 255 244

A Forward Rate Agreement, or FRA, is an agreement between two

who want to protect themselves against future movements in

By entering into an FRA, the parties lock in

The BUYER of the FRA enters into the

SFM by CA PRAVINN MAHAJAN

9871 255 244

The SELLER of the FRA wants to protect itself

STATED PERIOD OF TIME

Forward Rate Agreements can be used for

Arbitrage Arbitrage in FRAs enables speculators to make profits

SFM by CA PRAVINN MAHAJAN

9871 255 244

HEDGING THROUGH FRAs

PERIOD FOR WHICH LOAN

Mr. X will Borrow 1,00,000 after 3

SFM by CA PRAVINN MAHAJAN

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BANK A IS currently charging

AND CURRENT MIBOR IS 8%

BANK B will come to the rescue of X

SFM by CA PRAVINN MAHAJAN

9871 255 244

Whether FRA TO BE BOUGHT OR SOLD

WHAT TRANSACTION WILL

9871 255 244

Points To be kept in mind for hedging

Two Markets are needed for hedging. In this case

X will take a loan

On closing date i.e on exit date FRA is SOLD to bank B in

SFM by CA PRAVINN MAHAJAN

9871 255 244

has to Borrow 1,00,000 after 3 months for 6 months

He will Borrow From Bank A in delivery market after 3 months

will be his desired rate

SFM by CA PRAVINN MAHAJAN

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HOW FRA ENSURES THAT

RATE OF INTEREST INCREASES

SFM by CA PRAVINN MAHAJAN

Since Rate of FRA in Future Mkt

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X will buy FRA today from Bank B @ 9 + 2 = 11%

Meaning of Buying FRA

Practically FRA is bought

But after 3 months actual rate if 9.75 + 2% = 11.75% , thus

X will Sell FRA after 3 months to Bank B at 11.75%, thus providing a

X will actually borrow 1,00,000 from Bank A at 11.75%

On this date i.e on date of loan

Amount of gain receivable from Bank B

( Difference between M on date of

SFM by CA PRAVINN MAHAJAN

9871 255 244

X to Bank A after 6 months from date of loan. Gain

X is in the nature of compensation for additional interest payable by

X on date of loan, So bank B will pay present value

such additional interest