Interest Rate Forward and Futures Contracts

Say that Jersey Cola anticipates receiving payment in USD for a transaction that occurs in Europe, so Jersey will be depositing the funds received in USD at a European bank. And since Jersey has no immediate need for the funds, it plans on leaving the deposit at the bank to collect interest. What set of rates do you think the European bank uses to pay interest?

No. US rates would be used for USD deposits within the United States.

You got it!

International rates would be used for USD deposits outside the United States, called Eurodollars, and the main rate used _was_ the London Interbank Offered Rate, or LIBOR. Given some problems with manipulation, "LIBOR" has been largely replaced with the "market reference rate (MRR)" in the CFA curriculum. The MRR would determine the interest paid on Jersey's Eurodollar deposit. A lot of companies have an interest in MRRs. The total estimated value of Eurodollars is well over 100,000,000,000, so there are a lot of funds in this enormous market. And that much money causes companies like Jersey to engage in transactions to protect the valuable interest that those deposits can earn.

So to protect or grow the interest paid on the company's Eurodollar deposits, Jersey can use a __forward rate agreement__ (FRA), an over-the-counter forward contract in which the underlying is an interest rate on a deposit. An FRA has two counterparties, one that receives the floating rate, and one that receives the fixed rate. That also means that each receiver pays a rate of interest. What rate do you think the fixed receiver pays?

No. Then the fixed rate payer would also pay the same rate, so there's no benefit.

No. That's a swap, not an FRA.

Say that Jersey is concerned that the MRR would spike while waiting to receive the payment for its transaction. How would it structure the FRA?

Understandably, this can be confusing, so it's best to think of FRA convention as an equation. FRA Time Period (in months) + MRR Determining Rate (or Deposit Time Period) = Total Time Period So again, Jersey wants three months of interest rate protection on its future six-month deposit. So that means that the change in the six-month MRR will determine the payoff, three months after the FRA is initiated.

No. The FRA contracts don't assume a short position in fixed payments.

No. It's either a long or short position since both parties have counterparty risk.

You got it! Since FRAs naturally assume a fixed payer position to avoid arbitrage opportunities, Jersey would go long the FRA to pay fixed and receive floating. That way if MRR rises as assumed, Jersey would receive additional interest.

There are two ways to settle the transaction for the FRA. The first is called __settled in arrears__, which occurs when the payment is made at the end of the deposit period, also known as the maturity of the underlying. So in Jersey's case, the FRA would be settled at the nine-month mark. The second way is called __advanced set__ or __advanced settled__, which settles the transaction after the FRA expires because that's when the rate is set. Under advanced settled, the FRA for Jersey would expire in three months, and then FRA would settle. So knowing that, which way do you think most investors prefer?

Not quite.

You got it!

Investors typically want funds as soon as the contract details are finalized, so advanced settled is the preferred method for FRAs. But there are times when settled in arrears is used, especially when it comes to interest rate swaps and interest rate options.

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Now think about how Jersey would need to structure its FRA. Say that Jersey anticipates receiving payment in three months and plans on leaving the deposit at the European bank for six months. In this case, market convention refers to the Jersey FRA as a 3 x 9, where 3 indicates the FRA period in months, and the 9 indicates the total length of time in months. So the payoff of the transaction is determined by the six-month MRR, or the same period of time that Jersey is depositing its funds.

Exactly! The fixed receiver pays floating in exchange for receiving fixed. And it's the opposite for the floating receiver, who would pay fixed. Since there's no initial exchange of cash, FRAs are based on the fixed interest rate so no arbitrage opportunities exist. That means that FRAs naturally assume a position in paying fixed.

US rates

International rates

Fixed

Floating

S&P 500 dividend yield

Long

Short

Neutral

Settled in arrears

Advanced settled

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