23: Introduction to Financial Risk Managementthe spot rate declines to $0.5800/SF, then the SF10 million payment will be worth only $5,800,000
($0.5800/SF × SF10,000,000) rather than the $6,050,000 ($0.6050/SF × SF10,000,000) it would be
worth today.
This type of foreign exchange risk can be hedged by selling the payment forward. Suppose the
three-month forward rate for exchanging Swiss francs into dollars is $0.6051/SF. In three months, after
receiving the SF10 million payment, the company will deliver SF10 million to the counterparty in the
forward contract and receive in exchange $6,051,000 ($0.6051/SF × SF10,000,000), regardless of what
the spot rate happens to be at that time. The treasurer has hedged the company’s foreign exchange risk
associated with this payment by locking in the dollar price that the company will receive for its foreign
currency cash flow.
23-2c INTEREST RATE FORWARD CONTRACTS
The underlying asset in an interest rate forward contract is either an interest rate or a debt security.
Contracts involving an interest rate as the underlying security are cash settled, which simply means
that the underlying security is not transferred from the seller to the buyer. Instead, the buyer and seller
exchange the cash value of the contract. Either way, interest rate forward contracts are used to hedge
an interest rate risk exposure in much the same way that currency forward contracts are used to hedge
a currency risk exposure.
Forward Rate Agreements
A forward rate agreement (FRA) is a forward contract where the underlying asset is not an asset at all but an
interest rate. An FRA is an agreement between two parties to exchange cash flows based on a reference
interest rate and principal amount at a single point in time in the future. In an FRA, the first party will
pay the second party if the market rate of interest at a specified future time is greater than the fixed
interest rate (that is, the forward rate) specified in the contract. If, however, the market rate of interest is
less than the forward rate, the second party will pay the first party. The size of the payment will depend on
the hypothetical principal amount, called the notional principal, and the difference between the market
rate of interest and the forward rate. Equation 23.4 shows how to determine the cash flow in an FRA
(CFFRA). Note that, by convention, this computation uses a 360-day year.
Eq. 23.4
()()
()=
×− ×
×
CF
np rr D
rD
/ 360
1+ / 360
FRAsfwdsIn this equation, np stands for the contract’s notional principal, rs is the reference rate on the contract
settlement date (for example, the three-month Treasury bill rate), rfwd is the forward rate established at
the beginning of the contract, and D is the number of days in the contract period.
Hedging with Interest Rate Forward Contracts
To see how FRAs can be used to hedge interest rate risk, consider AuAg Commodities (AuAg). The
company is planning to borrow $10 million in six months at LIBOR plus 100 basis points, and is
concerned that LIBOR will increase before the company borrows.^4 To hedge this exposure, AuAg and
Bank Oz enter into a six-month FRA with a notional principal of $10 million. The terms of the contract
4 LIBOR, the London Interbank Offered Rate, is the rate of interest charged for Eurodollar borrowing between banks. Most large bank loans are
priced with reference to LIBOR.
forward rate agreement
(FRA)
A forward contract in which
the underlying asset is not
an asset at all but an interest
rate