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SCMP Reporter

FORWARD Rate Agreements, or FRAs, are deals between banks and clients which allow borrowers and investors to lock in an interest rate on an agreed loan or deposit for a specified period.

FRAs can be made to cover bank loans, time deposits, certificates of deposit, commercial paper or bankers acceptances.

Say, for example, a company treasurer wants to protect the next two roll-overs on some floating rate bank loans from possible rises in interest rates.

The loans are linked to the Hong Kong Interbank Offered Rate (HIBOR).

The roll-overs are due in a month's time and four months' time.

The treasurer takes out two FRAs. The first, to cover the roll-over a month ahead, is called a '1s versus 4s' because it relates to the three-month HIBOR rate a month ahead, or four months from the time the FRA was struck.

The second is called a '4s versus 7s' because it relates to the three-month HIBOR rate four months ahead, or seven months from the date of striking the FRA deal. The 1s versus 4s FRA was struck at 5.92 per cent and the 4s versus 7s at 5.82 per cent.

In a month from entering the FRA, three-month HIBOR is compared to the agreed rate of 5.92 per cent.

 If HIBOR is higher, the bank pays the company the discounted difference but, if it is lower, the company pays the bank.

 The same process applies to the 4s versus 7s FRA.

The FRA market, like all others, has its jargon. An FRA to cover a three-month loan in three months' time is a '3s versus 6s' (three month HIBOR three months ahead), while one to cover a six-month loan in three months' time is a '3s versus 9s' (three-month HIBOR six months ahead).

As in the example above, companies buy FRAs to protect loans from rising rates but they can also sell them to protect a deposit.

The example deals with two separate roll-overs but it is important to note that settlements are made up front.

 A client company taking out a bank loan in a month's time and protecting itself from rate rises by buying an FRA would receive a cheque on the starting day of the loan if HIBOR has risen above the agreed FRA rate.

Likewise, the client would need to pay the bank immediately if there has been a favourable (downward) movement in HIBOR. Since the payment is made at the start of the loan period, it is discounted to present value at HIBOR.

For example, a company enters a FRA for a six-month $50-million loan at an agreed FRA rate of six per cent. On the day the loan starts, if six-month HIBOR has risen to, say, seven per cent, the bank will pay the company the present value of the one per cent differential.

The FRA is always independent of the underlying borrowing or investment but it can be tailored specifically to match the transaction.

Standard HIBOR periods are three, six, nine and 12 months but banks can accommodate requests for any period.

FRAs are available in most major currencies in amounts above $10 million and for up to two years.



FRAs 'lock in' safeguards