FORWARD CONTRACTS ON INTEREST RATES: FORWARD RATE AGREEMENTS

So far we have discussed forward contracts on actual fixed-income securities. Fixed-income security prices are driven by interest rates. A more common type of forward contract is the interest rate forward contract, more commonly called a forward rate agreement or FRA. Before we can begin to understand FRAs, however, we must exarnine the instruments on which they are based.
There is a large global market for time deposits in various currencies issued by large creditworthy banks. This market is primarily centered in London but also exists elsewhere, though not in the United States. The primary time deposit instrument is called the Eurodollar, which is a dollar deposited outside the Unites States. Banks borrow dollars from other banks by issuing Eurodollar time deposits, which are essentially short-term unsecured loans. In London, the rate on such dollar loans is called the London Interbank Rate. Although there are rates for both borrowing and lending, in the financial markets the lending rate, called the London Interbank Offer Rate or LIBOR, is more commonly used in derivative contracts. LIBOR is the rate at which London banks lend dollars to other London banks. Even though it represents a loan outside of the United States, LIBOR is considered to be the best representative rate on a dollar borrowed by a private, i.e., non-governmental, high-quality borrower. It should be noted, however, that the London market includes many branches of banks from outside the United Kingdom, and these banks are also active participants in the Eurodollar market.
A Eurodollar time deposit is structured as follows. Let us say a London bank such as NatWest needs to borrow $10 million for 30 days. It obtains a quote from the Royal Bank of Scotland for a rate of 5.25 percent. Thus, 30-day LIBOR is 5.25 percent. If NatWest takes the deal, it will owe $10,000,000 X [l + 0.0525(30/360)] = $10,043,750 in 30 days. Note that, like the Treasury bill market, the convention in the Eurodollar market is to prorate the quoted interest rate over 360 days. In contrast to the Treasury bill market, the interest is not deducted from the principal. Rather, it is added on to the face value, a procedure appropriately called add-on interest. The market for Eurodollar time deposits is quite large, and the rates on these instruments are assembled by a central organization and quoted in financial newspapers. The British Bankers Association publishes a semiofficial Eurodollar rate, compiled from an average of the quotes of London banks. The U.S. dollar is not the only instrument for which such time deposits exist.
Eurosterling, for example, trades in Tokyo, and Euroyen trades in London. You may be wondering about Euroeuro. Actually, there is no such entity as Euroeuro, at least not by that name. The Eurodollar instrument described here has nothing to do with the European currency known as the euro. Eurodollars, Euroyen, Eurosterling, etc. have been around longer than the euro currency and, despite the confusion, have retained their nomenclature. An analogous instrument does exist, however-a euro-denominated loan in which one bank borrows euros from another. Trading in euros and euro deposits occurs in most major world cities, and two similar rates on such euro deposits are commonly quoted. One, called EuroLIBOR, is compiled in London by the British Bankers Association, and the other, called Euribor, is compiled in Frankfurt and published by the European Central Bank.
Now let us return to the world of FRAs. FRAs are contracts in which the underlying is neither a bond nor a Eurodollar or Euribor deposit but simply an interest payment made in dollars, Euribor, or any other currency at a rate appropriate for that currency. Our primary focus will be on dollar LIBOR and Euribor, so we shall henceforth adopt the terminology LIBOR to represent dollar LIBOR and Euribor to represent the euro deposit rate. Because the mechanics of FRAs are the same for all currencies, for illustrative purposes we shall use LIBOR. Consider an FRA expiring in 90 days for which the underlying is 180-day LIBOR. Suppose the dealer quotes this instrument at a rate of 5.5 percent. Suppose the end user goes long and the dealer goes short. The end user is essentially long the rate and will benefit if rates increase. The dealer is essentially short the rate and will benefit if rates decrease. The contract covers a given notional principal, which we shall assume is $10 million.