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    Valuation of A Forward Rate Agreement (Pp. 95-96) : Example: You Agree To Borrow $100 From September 1

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    Reza Al Saad
    A forward rate agreement (FRA) is a forward contract where an interest rate RK will apply to a principal amount for a future time period. The value of an FRA depends on the current forward rate RF. If RF is less than RK, the FRA has positive value for the party receiving RK. An interest rate swap can be valued by discounting the fixed payments and floating payments using LIBOR rates, with the swap value being the difference between the present values. The example calculates the value of a swap where the bank pays LIBOR and receives 8%.

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    Valuation of A Forward Rate Agreement (Pp. 95-96) : Example: You Agree To Borrow $100 From September 1

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    Reza Al Saad
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    A forward rate agreement (FRA) is a forward contract where an interest rate RK will apply to a principal amount for a future time period. The value of an FRA depends on the current forward rate RF. If RF is less than RK, the FRA has positive value for the party receiving RK. An interest rate swap can be valued by discounting the fixed payments and floating payments using LIBOR rates, with the swap value being the difference between the present values. The example calculates the value of a swap where the bank pays LIBOR and receives 8%.

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    A forward rate agreement (FRA) is a forward contract where an interest rate RK will apply to a principal amount for a future time period. The value of an FRA depends on the current forward rate RF. If RF is less than RK, the FRA has positive value for the party receiving RK. An interest rate swap can be valued by discounting the fixed payments and floating payments using LIBOR rates, with the swap value being the difference between the present values. The example calculates the value of a swap where the bank pays LIBOR and receives 8%.

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    Download as PDF, TXT or read online from Scribd
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    40 views5 pages

    Valuation of A Forward Rate Agreement (Pp. 95-96) : Example: You Agree To Borrow $100 From September 1

    Uploaded by

    Reza Al Saad
    A forward rate agreement (FRA) is a forward contract where an interest rate RK will apply to a principal amount for a future time period. The value of an FRA depends on the current forward rate RF. If RF is less than RK, the FRA has positive value for the party receiving RK. An interest rate swap can be valued by discounting the fixed payments and floating payments using LIBOR rates, with the swap value being the difference between the present values. The example calculates the value of a swap where the bank pays LIBOR and receives 8%.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 5

    Notes for Lecture 4 (February 21)

    Glenn Shafer

    Valuation of a Forward Rate Agreement (pp. 95-96) A forward-rate agreement (FRA) is a forward contract where it is agreed that a certain interest rate RK will apply to a certain principal to a specified future time period.
    Example: You agree to borrow $100 from September 1, 2002 to December 31, 2002 at 6% interest.

    The value of such a contract depends on the current forward rate RF.
    If the current September 90-day forward rate is 6%, then the contract just mentioned has value zero. If that forward rate is less than 6%, then the value of the FRA to the party receiving the 6% is positive.

    The value of the FRA to the party who is to receive RK is. L(RK RF)(T2 T1)e-R2T2. This is the present value of L(RK RF)(T2 T1) at time T2. Why? You can get an FRA with interest rate RF for free. If you combine the paying side of this RF-FRA with the receiving side of the RK-FRA, your only cash flow will be L(RK RF)(T2 T1) at time T2. So the value of the combination, which is also the value of the RK-FRA, is the present value of this time T2 payment. Hull: An FRA can be valued by assuming that the forward interest rate is certain to be realized.
    1

    Notes for Lecture 4 (February 21)

    Glenn Shafer

    Valuation of a Swap A plain-vanilla swap can be thought of in two different ways, which lead to two different ways of valuing them: You are swapping a bond with fixed-rate payments for a bond with floating-rate payments.
    The fixed-rate bond can be valued as in the preceding chapter, discounting each coupon payment using the zero-coupon rate for its date. The floating-rate bond has its face value as its present value, immediately after the payment of a coupon.

    You are making a bundle of forward rate

    agreements, together with some agreements that have value zero to both parties.
    Say the interest payments are at 6-month intervals. Then on July 1, 2003, you receive a payment at the fixed rate, say RK, and you pay the floating rate in effect on January 1, 2003. The agreement to accept the fixed rate RK is a forward rate agreement, which can be valued as on the preceding page. The agreement to pay the floating rate has value zero.

    Notes for Lecture 4 (February 21)

    Glenn Shafer

    Either way, it is customary to discount using LIBOR. The use of LIBOR rates hides an implicit assumption: both parties have the creditworthiness of large banks. If there is no risk of default, then the prices have the solidity of arbitrage arguments. But in practice, there may be substantial risk of default, and therefore the prices are less reliable than prices in an organized futures market. The risk is different for different parties. If Company A swaps with Company B, and Company A has a better credit rating, then Company A has greater risk. If a large bank plays the role of financial intermediary, it is assuming most of the risk. This has implications for the proper accounting of swaps.

    Notes for Lecture 4 (February 21)

    Glenn Shafer

    Example 5.1
    Bank has agreed to pay 6-month LIBOR and receive 8% (semiannual) on $100 million. Remaining life: 1.25 years. LIBOR (continuous) 10% for 3 months 10.5% for 9 months 11% for 15 months. The LIBOR 6-month rate at the last payment date (3 months ago) was 10.2% (semiannual) What is the value of the swap?

    Fixed payments are $4m. Floating payment due in 3 months is $5.1m. Value of fixed bond is
    Bfix = 4e-0.1x0.25 + 4e-0.105x0.25 + 104e-0.11x0.25 = $98.24 m

    Value of floating bond is


    Bfl = (100 + 5.1)e-0.1x0.25 = $102.51 m

    Value of swap is
    98.24 102.51 = $4.27 million

    Notes for Lecture 4 (February 21)

    Glenn Shafer

    Problem 5.19 Under the terms of an interest rate swap, a financial institution has agreed to pay 10% per annum and to receive three-month LIBOR in return on a notional principle of $100 million with payments being exchanged every three months. The swap has a remaining life of 14 months. The average of the bid-ask fixed rate currently being swapped for three-month LIBOR is 12% per annum. All rates are compounded quarterly. The three-month LIBOR one month ago was 11.8% per annum (quarterly compounding). What is the value of the swap? Hint: Convert the 12% to continuous compounding (this gives 11.82%) and use it as the LIBOR of all maturities to discount the future payments for both the fixed and floating rate bonds. But of course the 3-month LIBOR one month ago defines the payment on the floating rate bond one month from now.

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