Long side of an FRA receives...

CFA Level II
#1

Running across one of the questions in the CFAI cirriculum with regards to Forwards and came across a question that asked:

Somone wishes to hedge against an increase in future borrowing costs due to a possible rise in short-term interest rates. They proposed a hedge by entering into a long 6 × 12 FRA.

So before I even go on… if they propose a hedge by entering into a long FRA, does this mean that they will receive floating and pay fixed? That’s how I’ve understood it in the past

We’re giving the following rates as well:

Term (Days) Interest Rate (%) 30 5.10 90 5.25 180 5.70 360 5.95 With no additional information given we are asked Calculate the rate the Treasuer would receive on a 6x12 FRA . Once again, I had always thought that if you were long an FRA then you received Floating Rate… Evenutally they calculate this answer by taking 5.95 and discounting / 5.7 and discounting, etc. Just like you would to calculate a fixed rate. I’m not necessarily worried about the calculation. I guess ultimately my question becomes: If I am long an FRA, does this mean I receive floating? If so, why did the CFAI calculate the rate the treasuer receives with the above mentioned method? Thanks! Calculate the rate the treasurer would receive on a 6 × 12 FRA.

#2

Thinking through it now, I suppose at inception the rates would have to net eachother out, so whether you’re long or short, at inception you’d receive the same rate?

Going forward, lets say one period next, this rate would be what the long party pays, and we’ve yet to determine what he receives…

Am I on the right track?

If I am, I think it’s a poorly worded question; could have just been asked what the rate was @ inception instead of what rate does the Treasuer receive

#3

Long pays fixed, receives floating:

#4

Think of it like this, he wants to hedge against increase in borrowing costs, so he’s looking to lock in a fixed rate he’d pay. If he’s paying fixed rate, he’ll receive floating.

#5

Perhaps a better way to think of it is that in all other derivatives, the long gains when the value of the underlying increases. So it is with FRAs as well.

For an FRA, the only underlying that can increase is the floating rate, and when it increases you gain when you’re receiving it, not when you’re paying it. Thus, the long receives the floating rate.

#6

Ibid S2000!! :slight_smile: