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Chapter 11

2.3 How does the bank set the interest rate for an FRA?

FRA rates are set by the bank by analysing a company's spot yield
curve.

Example 1

A company’s yield curve has been calculated as:

1 year: 3.96%

2 year: 4.25%

3 year: 4.56%

i.e. the company will have to pay interest of 3.96% if it wants to borrow money
for 1 year, 4.25% if it wants to borrow for 2 years etc.

The 12-24 FRA rate will be the rate (r) which satisfies the equation:

2
1.0396 × (1 + r) = 1.0425
because the company could either borrow for 2 years at 4.25% throughout, or
for 1 year at 3.96% and then the second year at the 12-24 FRA rate.

Rearranging this gives the 12-24 FRA rate of 4.54%.

Illustrations and further practice

Now try Illustration 2 and TYU 1 in Chapter 11

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