hala_madrid Wrote: ------------------------------------------------------- > 100% agree, ws > > Perhaps my previous post was confusing. My point > is: > > 1. Payoff of the 1 year FRA at maturity will be: > > notional x (LIBOR - 5%) > > 2. Interest on the loan will be: > > notional x (LIBOR + 150 bps) > > 3. So basically you will get (LIBOR - 5%) - (LIBOR > + 150 bps) = -5% - 150 bps = -6.5% > I don’t have the book, but I think this is not true. As written, this isn’t even an FRA as the manager contracts to borrow at LIBOR +150 which is just a commitment for a floating rate loan. Now if we say that the 3.5% was the forward rate or something so that this becomes an FRA we still don’t get 6.5% but 5%. > 4. With the FRA, you effectively locked 6.5% as > your interest cost. As you say, if LIBOR goes > down, worse for you because you would have locked > in a higher rate (and viceversa, if LIBOR goes up, > better for you because you would have locked in a > lower rate) > > 5. But my point is that, one month into the FRA > contract (so, 5 months until you get the loan, and > 17 months until expiry of the FRA), the only > credit risk in this situation is the one > associated with the FRA, as the loan doesn´t even > exist. So the calculation of “5% - 4.5%” they do > makes no sense to me, as you should only take into > account the FRA payoff which is LIBOR - 5% (so > 4.5% would not be included) > > 6. Regardles of the “amount” of credit risk at > maturity, even assuming that “5% - 4.5%” as they > use is correct, the discount rates the use to get > the pv of that also don´t make sense. First, > because they use “current LIBOR” to get the value > in 5 months of the final settlement (which would > happen in 17 months), which by definition should > be done using a forward rate (I guess some 12 rate > in 5 months time), not “current LIBOR”. And > secondly, because once they get that “value in 5 > months”, to get the pv today they use “current > risk free rate” of 2.8% (again, without specifying > what is that “risk free rate”, tenor, etc) > > Anyway, as I said, I would not spend a lot of time > on this one, as I think this is not in the > curriculum > > thx I agree that this question looks messed. I think the forward rate agreement credit risk can only be estimated using forward rates and it’s just the PV of the FRA at the time you are valuing the credit risk. For this situation, after 1 month the FRA has value given by discounting the payoff you get at FRA expiration in 5 months by the 5 month spot rate (do we have that?). The payoff of the FRA is the value of that loan at expiration of the FRA Pv’ed by the spot LIBOR rate.
Joey, how come we discount payoff of FRA using PV and not borrowing cost of counter party?
It’s part of the settlement of the FRA (which BTW is usually under standard terms but an FRA is an OTC derivative so you could put anything you want in there). The standard “reference rate” is LIBOR.
It is part of the settlment which discount to use?
So the manager calls up the FRA desk at BSC (disconnected, oops) … at LEH and asks them for an FRA quote. They will quote him a rate like 6% and send him an agreement. The agreement will have terms in it which lay out how the are going to settle the FRA. Part of those terms are that when the FRA settles, they are going to take some reference rate use it to discount the net interest payment to settlement date. That rate will almost certainly be LIBOR. Now if you ask me what the value is of the credit risk and how you should discount that, I guess I am not sure. If someone says “This guy owes us $1M in 6 months, what’s the credit risk?”, I would answer $1M not some PV of $1M. I don’t know what’s in the curriculum though.
I read the CFAI readings for SS12 and there was no reference to FRAs at all. Schweser should have removed that example with FRAs from that SS.