Question

Consider a Forward Rate Agreement (FRA) in which a trader will pay a rate of interest of 5% per annum with quarterly compounding and receive LIBOR on a principal of $1 million for the three-month period starting on December 30. Suppose that on December 30 the three-month LIBOR proves to be 5.4% per annum with quarterly compounding. What is the cash flow for the trader?

Answer 1

FRA is a OTC contract between two agreed upon the exchange of the cash flows of the fixed and floating for the period of the borrowing term. but this borrowing term will not start immediate there is a contract rest period when it ends the Floating or LIBOR rate for the tenure of the borrowing is considered for the Floating rate.

Cash Flows for the Trader Long on FRA or receiving the Fixed paying Floating. Means Trader is receiving the 5.4% interest cash flows from the other party while paying the 5% interest on the principal borrowed.

Assuming that the interest is exchanged at the end of the quarter(30th dec + 0.25 year = at 30th March)

So the Cash Flow for the Trader are as follows:-

Year	Fixed Interest Paid @5%	Floating interest Recieved @5.4%
30th March	= 5%*(0.25) of $1 million = -$12,500	= 5.4%*(0.25) of $1 million = +$13,500

So at the 30th March end of the borrowing period the net cash flows for the Trader is = Cash Inflows - Cash outflows

= $13,500 - $12,500

= $1,000

The PV of Cash flows at 30th Dec = $1,000/(1 + 0.054*0.25)

= $986.68