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I'm completely befuddled by FRAs - forward rate agreements. Take a look at this definition

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....But, how EXACTLY does that fix an interest rate for me at all? There's nothing in that definition that indicates that any interest rate has been fixed.

Say I want to borrow 1000 dollars a month from now and pay it back 1 month later, and I'd like to do it at a fixed rate. Say, the forward rate is 5 %. That means I'd like to RECEIVE 1000 dollars a month from now and PAY 1050 dollars 2 months from now.

But if I enter into an FRA, and let's say LIBOR rate also turns out to be 5 % a month from now, then I will RECEIVE 1050 dollars two months from and I will PAY 1050 dollars two months from now. That equals 0.

So how the hell did that fix an interest rate for me? It did nothing for me? I still have to pay back my loan too at some libor rate?

  • Oh, I got it. If libor turns out to be, say, 6 %, then I will pay 1050 dollars, receive 1060 dollars, meaning I am 10 dollars in the plus. Then when I need to pay back my loan, I will only pay 5 % (the 1050) and then I can use the +10 dollars to pay the remaining loan. If Libor happens to be less than 5 %, my "payoff" will be negative, but on the other hand, my rate on my loan will be less as well, so the difference balances out and I end up with my 5 % fixed loan. THat's so fkkking easy and simple, why do books explain this so goddamn poorly? – OOE Nov 14 '18 at 20:02
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I'm not certain your comment illustrates the actual purpose of FRAs, so let me offer another example.

Suppose you borrow money for one year at LIBOR + 1%. Since you do not know what LIBOR rates will be in one year, you want to eliminate that interest rate risk.

So you ask a trader for a quote on an FRA at LIBOR + 1%. The trader is willing to create an FRA where you pay 5% fixed and the trader pays you LIBOR + 1%.

Now, Regardless of the LIBOR rate at any point, you will pay 5% interest, since you will receive LIBOR+1% from the trader and pay that same amount to the bank.

So the FRA is designed to turn your floating-rate loan into a fixed-rate loan.

  • Yes, this is exactly what my comment describes. You have a loan and the obligations that arise from it. But the FRA provides a "bonus" payoff that you can use to balance your loan obligations so that, essentially, you end up always paying a fixed-rate. So if LIBOR is higher, then you, as a borrower, need to pay more, but your FRA "bonus" will also be higher, and everything cancels exactly so that you pay the fixed rate. – OOE Nov 14 '18 at 21:02
  • This is the part that is incorrect: "Then when I need to pay back my loan, I will only pay 5 % (the 1050) and then I can use the +10 dollars to pay the remaining loan." If LIBOR is at 6%, then you'd pay 6% on your loan - there's not a "gain" of $10. The FRA is not a "bonus" - its increases or decreases in payoff are offset by changes in the loan interest payments. – D Stanley Nov 14 '18 at 21:19
  • Read that sentence again. I am paying 6% on my loan. I literally use the words remaining loan to acknowledge the fact that paying 5% on my loan isn't going to cut it. I just split it up into a part that equals 5% and a part that corresponds to what I'll make from FRA anyways. – OOE Nov 14 '18 at 21:24
  • OK I see that now. Feel free to add your comment as an answer to your own question (that's perfectly acceptable here). If you want to do that I'll delete my answer since it says the same thing in a different way. – D Stanley Nov 14 '18 at 22:01

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