Forward Rate Agreements and Swaps

For calibration of discount curves from swap rates, see my post on Bootstrapping the Discount Curve from Swap Rates.

In this post I’m going to introduce two of the fundamental interest rate products, Forward Rate Agreements (FRAs) and Swaps. FRAs allow us to ‘lock in’ a specified interest rate for borrowing between two future times, and Swaps are agreements to exchange a future stream of fixed interest payments for floating ones, or visa-versa. Both are model independent, which means we can statically hedge them today using just Zero Coupon Bonds (ZCBs) – so their prices won’t depend on our models for interest rates or underlying prices etc. ZCBs really are fundamental here – if you haven’t read my earlier post on them yet I recommend starting there!

First, a note about conventions. In other contexts, I’ve used r to be the continuously-compounding rate, such that if I start with $1, by time t it will be worth \exp \bigl( \int_0^t r(t')dt' \bigr) . In the rates world, this would be very confusing, and rates are always quoted as simple annualised rates, so that $1 lent for half a year at 5% would return $1.025 exactly in half a year’s time (note the additional factor of 0.5 coming from the year-fraction of the deposit), and this rates convention will be used throughout this post.

Each ZCB gives us a rate at which we can put money on deposit now for expiry at a specific time, and we can construct a discount curve from the collection of all ZCBs that we have available to us. In the case of a ZCB, we deposit the money now and receive it back at expiry. A Forward Rate Agreement extends the idea of putting money on deposit now for a fixed period of time to putting it on deposit at a future date for a specific period of time. We’ve picked up an extra variable here – our rate r(T) for deposit starting now depends only on time of expiry T, while the FRA rate f(t,T) will depend on the time that we put the money on deposit t as well as the time of expiry T.

An FRA, just like a deposit, involves two cash flows. We pay the counterparty a notional M at time t, and receive our notional M plus interest of (T-t)\cdot f(t,T) \cdot M at time T; where the first term is the Year Fraction, the second is the Forward Rate, and the final is the Notional. Since f will be fixed when we sign the contract, we can hedge these two cash flows exactly at t=0 using ZCBs. The value of the FRA is the value of receiving the second sum minus the cost of making the first payment:

    \[{\rm FRA}_{price} = Z(0,T)\cdot \Bigl[ (T - t)\cdot f(t,T) + 1\Bigr]\cdot M - Z(0,t)\cdot M\]

This agreement is at ‘fair value’ if the forward rate f(t,T) makes {\rm FRA}_{price} = 0, and re-arranging gives

    \[f(t,T) = {1 \over T-t}\ \Bigr( {Z(0,t) \over Z(0,T)} - 1 \Bigl)\]

An FRA allows us to ‘lock-in’ a particular interest rate for some time in the future – this is analogous in rates markets to the forward price of a stock or commodity for future delivery, which was discussed in an earlier post. Note that the price of all FRAs is uniquely determined from the discount curve [although in reality our discount curve will be limited in both temporal resolution and maximum date by the ZCBs or other products available on the market which we can use to build it].

A Swap is an agreement to exchange two cash flows coming from assets, but not the assets themselves. By far the most common is the Interest Rate Swap, in which two parties agree to swap a stream of fixed rate interest rate payments on a notional M of cash for a stream of floating rate payments on the same notional. Although the notional might be quite large, usually only the differences between the payments at each time are exchanged, so the actual payments will be very much smaller. The mechanics are probably best demonstrated by example:

A swap is written on a notional $100Mn, with periods starting in a year and continuing for three years and with payments at the end of each three month period; to pay fixed annualised 5% payments, and floating payments at the three-month deposit rate (fixed at the beginning of each period). What payments actually get made?

The swap starts in a year’s time, but the first payment is made at the end of the first 3-month period, in 15 months time. At this time, the fixed payment will be 5\% \cdot M \cdot (3{\rm m} / 12{\rm m}). The floating payment will be whatever the three-month deposit rate was at 1 year, multiplied by the same prefactors, r_{\rm 1 yr}(0,3{\rm m}) \cdot M \cdot (3{\rm m} / 12{\rm m}) – let’s say that r_{\rm 1 yr}(0,3{\rm m}) is 4% (although of course we won’t know what it is until the beginning of each period, and the payment will be delayed until the end of the period) – then the net cash flow will be $250,000, paid by the person paying fixed to the person paying floating.

The same calculation happens at each time, and a payment is made equal to the difference between the fixed and the floating leg cash flow. Although the notional is huge, we can see that the actual payments are much, much smaller [be alert for newspapers quoting ‘outstanding notional’ to make positions seem large and unsteady!]. The convention for naming Swaps is that if we are receiving fixed payments, we have a receiver’s swap; and if we are receiving floating payments, it is a payer’s swap.

What is the point of this product? Well, if we have a loan on which we are having to pay floating rate interest, using a swap we can exchange that to a fixed rate of interest by making fixed rate payments to the counterparty and receiving floating rate payments back, which match the payments that we’re making on the loan. This is of use to companies, who need to handle interest rate risk and might not want to be exposed to rates rising heavily on money they’re borrowing. A bank holding a large portfolio of fixed rate mortgage loans but required to pay interest to a central bank at floating rate might engage in a swap in the reverse direction to hedge it’s exposure.

How can we price this product? It’s easy to price the fixed payments – since each is known exactly in advance, we can hedge these out using ZCBs. The value of the sum of the fixed payments is

    \[V_{\rm fixed} = M \sum_{n=0}^{N-1} x \cdot Z(0,t_{n+1}) \cdot \tau\]

where x is the fixed rate (5% in our example above), and \tau is the relevant year-fraction for each payment (0.25 in our example about). What about the floating payments? We have to think a little harder here, but it turns out we can use FRA agreements to hedge these exactly as well. The problem is that we don’t know what the three-month deposit rate will be in a year’s time. But we can replicate it: if we borrow an amount N in a year’s time, and put that on deposit for three months, we’ll receive back M \cdot(r_{1 yr}(0,3{\rm m}) + 1)\cdot (3{\rm m}/12{\rm m}) in 15 months. We know from our discussion above that we can enter an FRA to borrow N in a year’s time, and we’ll need to pay M \cdot (f(12{\rm m},15{\rm m})+1) \cdot (3{\rm m}/12{\rm m}) in 15 months time – so we can guarantee to match the payment profile of the floating leg using the forward rates for the periods in question. The value of the floating payments is therefore

    \[V_{\rm floating} = M \sum_{n=0}^{N-1} f(t_n,t_{n+1}) \cdot Z(0,t_{n+1}) \cdot \tau\]

    \[= M \sum_{n=0}^{N-1} Z(0,t_{n+1}) \cdot ({Z(0,t_n)\over Z(0,t_{n+1})} - 1)\]

    \[= M \sum_{n=0}^{N-1} (Z(0,t_n) - Z(0,t_{n+1}))\]

    \[= M \bigl(Z(0,t_0) - Z(0,t_N)\bigr)\]

Since we can fix the price of the two legs exactly by arbitrage right now, we can value the swap by comparing the present value of each leg

    \[V_{\rm swap} = V_{\rm fixed} - V_{\rm floating}\]

    \[= M \sum_{n=0}^{N-1} (x - f(t_n,t_{n+1}))\cdot Z(0,t_n) \cdot\tau\]

    \[= M \Bigl( Z(0,t_N) - Z(0,t_0) + \sum_{n=0}^{N-1} x \cdot Z(0,t_{n+1})\cdot \tau \Bigr)\]

As with FRAs, swaps are said to be at fair value when the values of the fixed and the floating rate match, and the overall value is zero. This is the fixed rate at which we can enter a Swap for free, and occurs when x = X such that

    \[X = { Z(0,t_0) - Z(0,t_N) \over \sum_{n=0}^{N-1} \tau\cdot Z(0,t_{n+1}) }\]

This is called the Swap Rate. It is fully determined by the discount curve, and as we shall see the reverse is also true – the Swap Rate is in 1-to-1 correspondence with discount curve. Of course, after a swap is issued the Swap Rate will change constantly, in which case the actual fixed payment will no longer match X and the swap will have non-zero value. If K is the swap fixed coupon payment and X is the current swap rate, then

    \[V_{\rm swap}= M \Bigl( Z(0,t_N) - Z(0,t_0) + \sum_{n=0}^{N-1} K \cdot Z(0,t_{n+1})\cdot \tau \Bigr)\]

    \[= M \Bigl( {Z(0,t_N) - Z(0,t_0)\over \sum_{n=0}^{N-1} \cdot Z(0,t_{n+1})\cdot \tau} + K \Bigr) \cdot \sum_{n=0}^{N-1} \cdot Z(0,t_{n+1})\cdot \tau\]

    \[V_{\rm swap}= M \cdot (K - X)\cdot \sum_{n=0}^{N-1} Z(0,t_{n+1})\cdot \tau\]

    \[V_{\rm swap}= M \cdot (K - X)\cdot B\]

where B = \sum_{n=0}^{N-1} Z(0,t_{n+1})\cdot \tau is called the annuity of the swap. The value is proportional to the difference between the swap rate and the swap fixed coupon.

Because of the number of institutions that want to handle interest rate risk resulting from loans, IR Swaps are one of the most liquidly traded financial products. Although we’ve derived their price here from the Discount Curve, in practice it is often done the other way around – Swaps often exist up to much higher maturity dates than other products, and Discount Curves at long maturities are instead constructed from the swap rates quoted on the market at these dates. This is a very important procedure, but financially rather trivial. I’m not going to cover it here but will probably come back to it in a short post in the near future.

As well as being important in their own right, FRAs and Swaps (along with ZCBs, of course) are the foundation of the rich field of interest rate derivatives. The right (but not obligation) to enter into an FRA – a call option on an FRA – is called a caplet, and a portfolio of such options on FRAs across different time periods is called a cap, since you have guaranteed a cap on the maximum interest you will have to pay over the whole period to borrow money (a put on an FRA is called a floorlet, and a sequence of these forms a floor, for similar reasons). An option to enter a swap is called a swaption, and these are also heavily traded wherever a borrower might want to re-finance a loan at a later date if interest rates move sharply. The pricing of these products becomes dependent on the underlying model that we assume for interest rates, and I’ll start to deal with them in later posts.