The forward contracts in which the underlying is an interest rate are called forward rate agreements. These are also referred to as FRAs. These instruments help the parties in managing their interest rate risk.
These are based on the interest rates such as LIBOR. If a party wants to borrow after 90 days for 180 days, then that party can enter into a 90-day FRA contract on 180-day LIBOR. This position is called as a long position in the FRA contract i.e. the party will take a loan at the predetermined rate after 90 days for the period of 180 days. If the 180-day LIBOR is greater than the FRA rate, then the long position will have a profit as he will get a loan at a lower FRA rate. If the FRA rate is greater than 180-days LIBOR at the contract expiration, then the long party will have a loss and the short party will have profit.
The short party will the party that wants to lend a loan for 180 days after the period of 90 days. The difference between the rates will lead to profit or loss at the contract expiry, and total monetary value depends on the notional principal of the contract.
Synthetic FRAs: Similar to other derivative instruments like forward and futures, FRAs are also priced based on the no-arbitrage principle. So, we can also create synthetic FRA position.
To take a long position in a 90-day FRA on 180-day LIBOR, one can buy a 270-day Eurodollar and sell 90-day Eurodollar. That will be equivalent to a long position in 90-day FRA on 180-day LIBOR.
For the short position in the above contract, the party needs to short 270-day Eurodollar and buy 90-day Eurodollar.
Check your concepts:
(58.10) How can a synthetic short position in 90-day FRA on 180-day LIBOR be replicated?
(a) Selling 270-day Eurodollar and buying 90-day Eurodollar
(b) Buying 270-day Eurodollar and selling 90-day Eurodollar
(c) Buying 180-day Eurodollar and selling 90-day Eurodollar
Solutions:
(58.10) Correct Answer is A: To replicate a synthetic short position in 90-day FRA on 180-day LIBOR, one needs to sell 270-day Eurodollar and buy 90-day Eurodollar.
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