Why is an FRA settled with a discounted cash payment at the start of the loan period?

Question

AcadiFi · Accepted Answer

The discounting quirk trips up nearly every candidate. The economic exposure of an FRA is to the interest that would accrue over the future deposit period, but settlement happens at the start of that period, not the end.

Unlock with Scholar — $19/month

Get full access to all Q&A answers, practice question explanations, and progress tracking.

Start 7-Day Free Trial Compare Plans

No credit card required for free trial

Consider Halverson Bank buying a 6x12 FRA at 5.00% on a $20 million notional. On the fixing date, the 6-month reference rate prints at 5.80%. The accrued interest difference over the forthcoming 6-month period would be $20,000,000 × (0.0580 − 0.0500) × 180/360 = $80,000. But if Halverson received this at the end of the 6-month period, it would be receiving full value. Since settlement occurs immediately, the $80,000 is discounted at the prevailing reference rate: $80,000 / (1 + 0.0580 × 180/360) = $77,745.

This present-value adjustment preserves no-arbitrage equivalence with an actual deposit position. If settlement weren't discounted, the FRA buyer could pocket $80,000 today, reinvest at 5.80% for six months, and earn more than a physical borrower who hedged with the FRA. The discount eliminates that free lunch and keeps the FRA economically equivalent to locking in borrowing or lending at the agreed rate.

Why is an FRA settled with a discounted cash payment at the start of the loan period?

Master Level II with our CFA Course

Related Questions

Practice Questions