Forward Rate Agreements (FRA)
A Forward Rate Agreement (FRA) is a forward contract on interest rates. While FRAs exist in most major currencies, the market is dominated by U.S. dollar contracts and is used mostly by money center banks.
An FRA is a cash-settled contract between two parties where the payout is linked to the future level of a designated interest rate, such as three-month LIBOR. The two parties agree on an interest rate to be paid on a hypothetical deposit that is to be initiated at a specific future date. The buyer of an FRA commits to pay interest on this hypothetical loan at a predetermined fixed rate and in return receive interest at the actual rate prevailing at the settlement date.
Assume that in December 2017, a June 2017 Eurodollar futures is priced at 99.10. This price reflects the market’s perception that by the June 2017 expiration, three-month LIBOR rates will be .90% (IMM Price convention= 100 – 99.10 = .90%). Eurodollars are really a forward-forward market and their prices are closely linked to the implied forward rates in the OTC market.
Eurodollars and FRAs
Just as stock index futures reflect the cash S&P 500 market and soybean futures reflect the spot soybean market, Eurodollar futures should price at levels that reflect rates or implied rates in the FRA market. In addition, Eurodollar futures prices directly reflect, and are a mirror of, the yield curve. This is intuitive if one considers that a Eurodollar futures contract represents a three-month investment entered into N days in the future. Certainly, if Eurodollar futures did not reflect IFRs, an arbitrage opportunity would present itself.
Consider the following interest rate structure in the Eurodollar (Euro) futures and cash markets. Assume that it is now December. Which is the better investment for the next six months:
Invest for six months at 0.80%;
Invest for three months at 0.70% and buy March Euro futures at 99.10 (0.90%); or
Invest for nine months at 0.90% and sell June Euro futures at 98.96 (1.04%)?
Assume that these investments have terms of 90- days (0.25 years), 180-days (0.50 years) or 270- days (0.75 years).
March Euro Futures 98.10 (0.90%)
June Euro Futures 98.96 (1.04%)
Three-month Investment 0.70%
Six-month Investment 0.80%
Nine-month Investment 0.90%
The return on the first investment option is simply the spot six-month rate of 0.800%. The second investment option implies that you invest at 0.700% for the first three months and lock in a rate of 0.900% by buying March Eurodollar futures covering the subsequent three-month period. This implies a return of 0.800% over the entire six-month period.
The third alternative means that you invest for the next 270 days at 0.90% and sell June Eurodollar futures at 1.04%, effectively committing to sell the spot investment 180 days hence when it has 90 days until maturity. This implies a return of 0.83% over the next six-months.
The third alternative provides a slightly greater return of 0.83% than does the first or second investment options with returns at 0.80%.
Eurodollar futures prices reflect IFRs in the FRA market because of the possibility that market participants may pursue arbitrage opportunities when prices become misaligned. Thus, one might consider an arbitrage transaction by investing in the third option at 0.83% and funding that investment by borrowing outright at the term six-month rate of 0.80%. This implies a three basis point arbitrage profit.
This module demonstrates the close linkage of the FRA and Eurodollar futures market. These contracts allow a firm to replace floating interest rates with fixed interest rates or vice-versa. FRAs are customized contracts that can be obtained through investment banks. These banks hedge the risk of these products by using Eurodollar futures. In hedging the sale of a forward contract with futures, the marking to market feature of futures must be considered. As a result, the pricing of FRAs is very competitive and bid-ask spreads are very narrow as arbitrage opportunities keep prices in the two markets very closely aligned.
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Peter Knight Advisor