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
you