As we saw in the article on future interest agreements or Forward rate agreement (FRA), these are financial derivatives on short-term interest rates where the underlying is an interbank deposit. We will see in a practical example of the use of term contracts (FRA) to better understand their operation.
Once we know the formulas that we will use and that we remember briefly, we will practice a 3 × 6 FRA settlement.
What does FRA 3 × 6 mean?
Interest rates at 3 months within 3 months.
- We calculate the implicit rates in the 3 × 6 FRA, that is, we want to know what interest rates the market says that there will be within 3 months with the data of the interest rates at 3 months (3.25%) and 6 months (4%).
The formula of the buyer and seller FRA are the same, and interestingly, it is the same as the formula for the calculation of implicit rates.
- We assume that we buy a 3 × 6 FRA for a nominal amount of 100,000 euros, so we are waiting for a rise in interest rates.
CASE 1: Interest rate rise
- In this case, on the start date they will practice us for having bought a 3 × 6 FRA for a positive settlement of € 446. This is due to the fact that interest rates have risen to 6% and therefore we have succeeded in the direction of movement of interest rates and how this amount is settled by differences in our account.
CASE 2: Interest rate drop
- In this case, on the start date they will practice us for having bought a 3 × 6 FRA for a negative settlement of € 304. This is because interest rates have dropped to 3% and therefore we have erred in the direction of interest rate movement and as it is settled by differences we pay the difference between the FRA rate and the interest rate of settlement.