What are forward rates? What are forward rate agreements? What is an FRA? - YouTube

Hello YouTube welcome back to my channel today we're going to learn about what

forward rates are and about a derivative called a forward rate agreement

Okay so let's first learn about what forward rates are a forward rate is a

term used in both fixed income and currency trading to describe the current

expectations of future bond interest rates or currency exchange rates. In

fixed income, or bonds the forward rate is calculated based on interest rates

for various maturities, these rates are usually plotted on a graph as a yield

curve. If an investor wishes to invest their money for a year in bonds there

are a few ways of doing that they can buy a one-year bond and hold it for the

year or they could buy a six-month bond and as soon as that one matures buy

another six-month bond. Under these two scenarios the investor knows the

interest rates for both the 1-year bond and the first six-month bond. They don't

know the actual interest rate for the second six-month bond that they will

eventually buy, because it's in the future and interest rates can change

between now and then. The forward rate thus is the predicted interest rate on

the second six-month bond that would allow the investor to earn the same

amount of interest under either scenario. Forward interest rates are watched

closely by investors as economic indicators. In currency markets the

forward rate is the agreed-upon rate at which the parties will exchange

currencies on a future date. These contracts are used by large companies to

hedge against currency fluctuations. Okay so now we know what a forward rate is,

it's just an interest rate implied for periods of time in the future by zero

coupon bonds. For example the market implied yield on a three-month Treasury

bill three months from now is a forward rate. If we know what the three months

zero coupon Treasury bill rate is and what the six month zero coupon Treasury

bill rate is we can back out what the market is implying as the yield

on a three-month Treasury bill three months from now. To calculate forward

rates we just need the zero coupon yield curve. Here is a forward rate calculation

example taken from my book "Trading and Pricing Financial Derivatives" which is

linked to in the description below. Suppose you have a two-year bond

yielding 3% and a 1-year bond yielding 2.4 percent. If you bought the 1-year

bond how much would you have to earn on a one-year bond, in one year's time to

have earned the same amount of interest as you would have earned by just buying

the 2-year bond? $100 invested in the 2-year bond would give us a hundred

times e to the three percent times two for two years or a hundred and six

dollars and 18 cents after two years. In order to get the same amount of money by

buying two consecutive one-year bonds the year 2 bond would need to pay us 3.6

percent. 100 dollars times e to the 2.4% times 1 times e to the 3.6% times one gives us a hundred and six dollars and 18 cents the same amount

of money. So the 1-year forward rate starting in one year's time must be

3.6%. Okay, so now that we know what a forward rate is what is a

forward rate agreement a forward rate agreement or FRA is an

over-the-counter agreement to borrow a fixed amount of money at a fixed

interest rate at a specified future time period. In plain English it's an

over-the-counter agreement to borrow or lend during a specified time period not

starting now. Banks and large corporations can use FRA's to hedge

future interest rate exposures. The buyer hedges against a risk of rising interest

rates while the seller hedges against the risk of falling interest rates.

Speculators can use FRA's to make bets on future changes in interest rates

rates in the future will usually be different from the implied

at the time you entered into a forward rate agreement, giving rise to gains or

losses on the agreed transaction. Suppose you agree to lend a hundred million

dollars for a six month time frame starting in two years to earn a 3.5%

return, two years passes and it turns out that the market

rate for the next six months is 4% this means you have a loss on

your original trade because obviously you could have invested at 4% while

instead you're investing at three and a half percent. Your cash flows will then

be at the end of the two and a half years, a hundred million times three and

a half percent minus four percent times zero point five giving us a loss of two

hundred and fifty thousand dollars. Hopefully that all makes sense to you if

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interest rate swaps have a great day bye

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