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Currency Forward Rate Agreement Example

By Zach Arnold | September 16, 2021

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The forward exchange rate is based solely on interest rate spreads and does not take into account investors` expectations of where the real exchange rate might be in the future. A FRA is actually a loan in advance, but without the exchange of capital. The nominal amount is simply used to calculate interest payments. By allowing market participants to act today at an interest rate that at some point will be effective in the future, LTPs allow them to hedge their interest rate risk in the event of a future commitment. The FRA sets the rates to be used at the same time as the date of termination and the nominal value. FRA are settled in cash on the basis of the net difference between the interest rate of the contract and the market variable rate called the reference rate. The nominal amount is not exchanged, but a cash amount based on price differences and the nominal value of the order. Rate difference = | (Billing rate – contract rate) | × (days in the term of the contract/360) × nominal amount futures contracts usually consist of two parties who exchange a fixed rate for a variable rate. The party paying the fixed interest rate is designated as the borrower, while the party receiving the variable interest rate is designated as the lender. The agreement on the rate in the future could have a maximum duration of five years. A borrower could enter into a rate agreement in advance for the purpose of guaranteeing an interest rate if the borrower believes that interest rates may increase in the future. In other words, a borrower might want to set their cost of borrowing today by entering into a FRA. The cash difference between the FRA and the reference rate or variable rate shall be paid on the date of the value or on the date of invoice.

If the billing rate is higher than the contractual rate, it is the seller fra who must pay the invoice amount to the buyer. If the contract rate is higher than the billing rate, FRA`s buyer must pay the invoice amount to the seller. If the contract rate and the settlement rate are the same, no payment is made. The trading date is when the contract is signed. The fixing date is the date on which the reference price is checked and then compared to the futures price. For the pound sterling, it is the same day as the settlement date, but for all other currencies, it is 2 working days before. If the FRA uses LIBOR, libor-Fix is the official quote of the price for the fixing date. The benchmark rate is published by the established body, which is usually published via Reuters or Bloomberg. Most FRAs use LIBOR for the contract currency for the reference rate at the date of fixing. In this case, the one-year term rate is therefore US$ = C$1.0655. Note that the Canadian dollar, since it has a higher interest rate than the U.S. dollar, is trading at a forward discount on the greenback.

Similarly, the real spot rate of the Canadian dollar in one year currently has no correlation with the one-year forward rate. How does a currency attacker work as a hedging mechanism? Suppose a Canadian export company sells $1 million of goods to a U.S. company and expects to receive the export proceeds within a year. The exporter is concerned that the Canadian dollar has strengthened from its current price (1.0500) in one year, meaning it would receive fewer Canadian dollars per U.S. dollar. The Canadian exporter therefore enters into a futures contract to sell in the future $ 1 million per year at a forward price of 1 US dollar = 1.0655 C$. There are, however, several ways to calculate the same thing, which are explained using the following examples. Let`s calculate the 30-day credit rate and the 120-day credit rate to deduct the corresponding term interest rate that, at the beginning, makes the value of the FRA equal to zero: a term rate is the interest rate for a future period. . .


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