Series X3.3 Solution

[Justin Pang]

Hi,

The solution to Series X3.3 states the following:

"An FRA is an agreement that locks in a specified interest rate based on a specified principal over an agreed future time period.
If an investor has a floating rate debt, on which each interest payment to be made is linked to LIBOR, he or she can use a series of FRAs to lock in a fixed rate at each interest payment date.
In this way a series of FRAs can convert a series of floating rate payments to fixed payments, which is the same as the function of a fixed/floating swap."

I understand that an FRA allows the investor to lock in fixed payments, but how is this converting the floating payments? Surely the investor is still liable to making their floating payments?

Thanks in advance for any explanation.

 

[Colin McKee]

Hi
The rationale is that if an investor has signed up to a series of LIBOR payments over the next (say) 5 years, they can arrange a series of FRAs over each of the next 5 years to "lock in" a fixed rate (say 2% pa). In each year, if the floating rate is <2%, the borrower will indeed still just pay the floating rate on the debt, but will then have to compensate the bank for the difference between 2% and the floating rate. So the net payment (floating interest + FRA derivative payoff) will equal 2%. If the floating rate turns out to be >2% then the investor pays the floating rate but gets a compensation payoff under the FRA for the difference between the floating and 2%, so again the net interest is just 2%.
If the investor had instead arranged a swap where he/she pays floating and received 2%, they would end up in the same situation, so the two are equivalent.