Forward Rate Agreement Pricing and Valuation: An Overview
Forward Rate Agreements (FRAs) are contracts between two parties where one party agrees to pay the other party a predetermined interest rate at a future date. The contract is essentially a bet on what the future interest rates will be. FRAs are commonly used in the financial industry to hedge against interest rate risks. In this article, we will take a closer look at FRA pricing and valuation.
FRA Pricing
FRA pricing is the process of determining the FRA`s fair value. The fair value is the amount that both parties are willing to pay and receive for the contract. FRA pricing is based on the following factors:
1. The notional amount: This is the amount that the interest rate will be applied to. It is usually a significant amount, for example, $1 million.
2. The FRA rate: This is the predetermined interest rate that will be paid at the future date.
3. The prevailing interest rate: This is the interest rate prevailing in the market at the time of contracting.
To calculate the FRA`s fair value, the following formula is used:
FRA`s fair value = Notional amount x (FRA rate – prevailing interest rate) x (days/360)
Where days represent the number of days between the start date of the contract and the future date. The division by 360 is used to convert the interest rate from an annual basis to a daily basis.
FRA Valuation
FRA valuation is the process of determining the FRA`s market value at any given time. The market value is the price that the FRA can be bought or sold. The valuation of an FRA can be done using the following two methods:
1. Black`s Model: This method is based on the Black-Scholes model used to value options. It is a mathematical formula that takes into account the FRA`s current market price, the notional amount, the FRA rate, the prevailing interest rate, and the time remaining until the future date.
2. Mark-to-Market: This valuation method involves calculating the FRA`s value based on the prevailing market interest rates. If the market interest rates are higher than the FRA rate, the FRA will have a negative value. If the market interest rates are lower than the FRA rate, the FRA will have a positive value.
Conclusion
In conclusion, Forward Rate Agreement Pricing and Valuation are crucial for financial institutions to manage their interest rate risks. FRA pricing involves determining the FRA`s fair value, which is based on the notional amount, the FRA rate, and the prevailing interest rate. FRA valuation is the process of determining the FRA`s market value at any given time and can be done using Black`s Model or Mark-to-Market valuation methods. Understanding FRA pricing and valuation is important for institutions to make informed decisions and manage their financial risks effectively.
