FRA Credit Risk Calculations

The payout for FRA is the delta interest at the loan maturity date and calculating the present value of this at the loan start date (which is the FRA expiration rate). This PV is to be done at market rate. If the loan rate is LIBOR + 150 bps, should the PV be done using LIBOR or LIBOR + 150 bps? ps: this is condensed version of a question in schweser SS#12, Book 4, Pg104, Q10. thanks, bn

You calcuate the payoff using LIBOR+150BPS. Comparing your borrow cost (LIBOR+150bps) to the strike rate (5% in this case). Once you figure out your payoff, find out the PV of payoff using market rate (3% in this case). Then discount backward using 2.8% (RFR). Confuing enough?

BN Wrote: ------------------------------------------------------- > The payout for FRA is the delta interest at the > loan maturity date and calculating the present > value of this at the loan start date (which is the > FRA expiration rate). This PV is to be done at > market rate. > > If the loan rate is LIBOR + 150 bps, should the PV > be done using LIBOR or LIBOR + 150 bps? > > ps: this is condensed version of a question in > schweser SS#12, Book 4, Pg104, Q10. > > > thanks, The PV is calculated using the borrowing costs for the firm (LIBOR + Spread). Similar to calculating the future value of an interest rate option to get the net amount borrowed or lent.

My question was specifically around discount rate to be used for the PV calcs to estimate value as of FRA expiration (which is the same period as loan start). I thought the discount rate should be the loan rate, which in this case is LIBOR + 150 bps. Schweser seems to use market rate (=LIBOR) for this discounting… Can someone clarify which is the correct discount rate to be used to estimate value at FRA expiration. PS: I do understand that the final PV for credit risk calcs is at Risk free rate. thanks, bn

BN Wrote: ------------------------------------------------------- > Can someone clarify which is > the correct discount rate to be used to estimate > value at FRA expiration. > You use LIBOR (market rate).

Hope this helps. |-------------------|--------------------------------------------| Initial----------FRA Exp.------------------------------------end of borrowing period

ws Wrote: ------------------------------------------------------- > BN Wrote: > -------------------------------------------------- > ----- > > Can someone clarify which is > > the correct discount rate to be used to > estimate > > value at FRA expiration. > > > > You use LIBOR (market rate). I think you’re right. So what’s the use of the Rf rate ? I am not sure if that has anything to do with this calculation ?

Read ws’ first post to see where to use rfr…

mo34 Wrote: > > > I think you’re right. So what’s the use of the Rf > rate ? I am not sure if that has anything to do > with this calculation ? FRA has a life, say 3 month. You use RFR to figure out the credit risk during the life of the FRA. For example, 1 month into the FRA, so you have to use RFR to discount back to current time to figure out the credit risk amount. Make sense? Let’s say FRA is for 3 month, borrow for 1 year, rate condition changes 1 month into the agreement. Looks like this 0 1 3 4 |-----------------|-----------------------------------------------| 0: FRA beginning. 1: 1 month into the FRA 3: FRA expiration 4: Payoff at end of borrowing period. So, use LIBOR+150bps (your borrowing cost) to compare with contract rate to find out the value at 4. Use the value at 4, discout back to 3 (FRA expiration) using LIBOR (market rate) to find out the value at FRA expiration. Use the value at 3, discount back to 1 (1 month into the FRA) using RFR to find our your current value of the FRA. (markint to market)

SH*T…the diagram didn’t come out the way I hoped. 0 is at the begining 1 is between the 1st and 2nd bar. 3 is on top of the 2nd bar. 4 is on top of the 3rd bar. 0***1*****3***********************4 |---------------|--------------------------------------| Try this…it didn’t like me putting space.

The time line makes it clear. When I answered the question I assumed he was asking about the value of the forward contract AFTER initiation but before expiration. ( sometimes between 3 and 4 in your time line) I agree, if it’s before initiation, you use Rf to get the PV.

Just to be clear. My time line between 3-4 is the borrowing period. 0-3 is the FRA period. 3 is the FRA contract exipiration point

ws, just to understand better, in the example have you used a 3*15 FRA?

CareerChange Wrote: ------------------------------------------------------- > ws, just to understand better, in the example have > you used a 3*15 FRA? 3 month is the FRA period, borrowing period is 12 month==> Yes, that is a 3X15 FRA.