25556 Chap.13 Hedging Interest Rate Risk with FRAs
Hedging Interest Rate Risk with FRAs
The second half of Topic 6 turns the forward rates of the yield curve into a risk management tool. Anyone who plans to borrow or invest next month, or who pays or earns a floating rate, faces the chance that the spot rate will differ from the forward rate the market expects today.
Borrowers are hurt when rates come in high and lenders when they come in low, so the two sides make natural counterparties.
This chapter measures that exposure in dollars for a planned bill issue and a planned purchase, then introduces the forward rate agreement: a no-cost, over-the-counter contract with a bank that locks in a forward rate through one cash settlement.
You will learn the month notation such as 1:4 and 3:6, how strips cover a bill facility, the course's settlement equation for discount securities, how to read its sign for a borrower and for a lender, and how to prove the effective rate equals the agreed rate.
What this chapter covers
- 01
Interest rate exposures of borrowers and lenders
- 02
Who holds rate exposures: bill facilities, institutions, fund managers
- 03
Forward rate agreements and their month notation
- 04
Strips of FRAs for a bill facility
- 05
The FRA cash settlement equation
- 06
Proving the effective rate equals the FRA rate
Worked example · free
Measure a borrower's and a lender's exposure on $40 million of bills at a 4.20% forward rate
- 1Planned value at the forward rate: 40,000,000 divided by (1 + 0.042 times 90/365) = $39,589,999.46.
- 1Value at the 4.80% spot rate: 40,000,000 divided by (1 + 0.048 times 90/365) = $39,532,113.07.
- 1Borrower: its bills raise $57,886.38 less than planned. Lender: it pays $57,886.38 less for the same face value, an equal and opposite gain.
- 1Lender side of a hedge: had the fund locked in 4.20% with an FRA, the settlement of $39,589,999.46 minus $39,532,113.07 = $57,886.38 would be added to its outlay, so it would hand its whole windfall to the bank and pay exactly the planned amount.
Key terms
- Interest rate risk
- The chance that future spot rates differ from the forward rates expected today, changing borrowing costs or investment returns.
- FRA strip
- A sequence of forward rate agreements covering consecutive periods, used to hedge every rollover of a bill facility.
- Notional principal
- The face amount on which an FRA settlement is calculated, which is never itself lent or borrowed.
- Bill facility
- A funding arrangement in which a business raises money by issuing bank bills and reissuing them each time they mature.
- Hedger
- A market participant who uses a derivative to reduce an existing risk exposure rather than to profit from one.
Hedging Interest Rate Risk with FRAs FAQ
What does 1:4 mean on a forward rate agreement?
The numbers count months from today. A 1:4 FRA fixes a rate for the period that starts in one month and ends in four, so it covers a three-month, or 90-day, borrowing or investment. A 3:6 FRA would cover the same length of period starting three months from now.
Who pays the FRA settlement when rates rise?
If the spot rate on settlement day is above the agreed rate, the bank pays the borrower, which offsets the smaller amount its bills raise. A lender in the same situation pays the bank, because the higher market rate already lets it buy the bills more cheaply. The direction flips when rates fall.
Does an FRA mean the borrower gets the loan from the bank?
No. The FRA only fixes the rate. The borrower still raises its funds by issuing bills or borrowing elsewhere, and the contract settles the difference between the agreed rate and the market rate in cash, so the combined outcome matches the forward rate.
Why can a hedged borrower not benefit when rates fall?
When spot comes in below the agreed rate the borrower's bills raise more than planned, but it must pay that gain away as the FRA settlement. The hedge removes both the loss from higher rates and the windfall from lower ones, leaving the agreed rate as the effective cost.
What are the advantages and drawbacks of FRAs?
They are tailored to each client, quick to arrange because the documentation is standard, cost nothing up front and carry low default risk because only the settlement is exchanged. The main drawback is that they trade over the counter with no secondary market, so a position cannot easily be sold before settlement.
Exam move
Start every FRA question by writing who the hedger is and which way rates hurt it, because the sign of the settlement only makes sense against that sentence. Practise the three-step routine on numbers you invent: value the bills at the market rate, compute the settlement with the course equation, then add it to the proceeds or the investment and show the effective rate returns to the agreed rate.
Do at least one borrower and one lender case with rates moving each way. Finally, practise naming strips for facilities that start at different dates, since the month notation is easy to misread under exam pressure. Time yourself on one full FRA question to see where the minutes go.
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