How to get my head around FRAs
I'm completely befuddled by FRAs - forward rate agreements. Take a look at this definition
....But, how EXACTLY does that fix an interest rate for me at all? There's nothing in that definition that indicates that any interest rate has been fixed.
Say I want to borrow 1000 dollars a month from now and pay it back 1 month later, and I'd like to do it at a fixed rate. Say, the forward rate is 5 %. That means I'd like to RECEIVE 1000 dollars a month from now and PAY 1050 dollars 2 months from now.
But if I enter into an FRA, and let's say LIBOR rate also turns out to be 5 % a month from now, then I will RECEIVE 1050 dollars two months from and I will PAY 1050 dollars two months from now. That equals 0.
So how the hell did that fix an interest rate for me? It did nothing for me? I still have to pay back my loan too at some libor rate?
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I'm not certain your comment illustrates the actual purpose of FRAs, so let me offer another example.
Suppose you borrow money for one year at LIBOR + 1%. Since you do not know what LIBOR rates will be in one year, you want to eliminate that interest rate risk.
So you ask a trader for a quote on an FRA at LIBOR + 1%. The trader is willing to create an FRA where you pay 5% fixed and the trader pays you LIBOR + 1%.
Now, Regardless of the LIBOR rate at any point, you will pay 5% interest, since you will receive LIBOR+1% from the trader and pay that same amount to the bank.
So the FRA is designed to turn your floating-rate loan into a fixed-rate loan.
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