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CHAPTER 12 FUTURE RATE AGREEMENTS

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TABLE OF CONTENTS

12 FUTURE RATE AGREEMENTS ...12-1

12.1 Introduction ...12-1 12.2 FRA.PARAMETER ...12-2 12.2.1 Future Rate Agreement Types ...12-2 12.2.2 General processing information...12-3 12.2.3 Accounting information...12-3 12.3 Inputting a FRA...12-4 12.3.1 Basic Information ...12-4 12.3.2 Additional Information ...12-6 12.3.3 Related Deals...12-6 12.4 FRA positions...12-7 12.4.1 Position Definition...12-7 12.4.2 Information held ...12-8 12.5 FRAs and Limits...12-9 12.6 FRA Position Management Interface ...12-10 12.6.1 Cash-Flow/Liquidity...12-10 12.6.2 Interest Gap ...12-10 12.6.3 FX Position ...12-10 12.7 FRA Accounting ...12-11 12.7.1 Specific rules for Trade Deals ...12-11 12.7.2 General FRA rules ...12-12 12.7.3 Accounting entries on deal date - all contracts ...12-13 12.7.4 Accounting entries from trade date to rate fixing ...12-13 12.7.4.1 Open trade contracts...12-13 12.7.4.2 Closed trade contracts ...12-14 12.7.5 Rate fixing ...12-15 12.7.6 Accounting entries on settlement date - trade contracts ...12-16 12.7.7 Accounting entries on settlement date - hedge contracts ...12-17 12.7.8 Accounting entries on late settlement date - trade contracts...12-18 12.7.9 Accounting entries on late settlement date hedge contracts...12-19 12.8 FRA Reports ...12-20 12.9 FRA calculations...12-21 12.9.1 Future Rate Calculation ...12-21 12.9.2 FRA Valuation...12-24

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12 FUTURE RATE AGREEMENTS

12.1 Introduction

The Future Rate Agreement module (FRA) supports processing for both Hedging and Trading purposes. The module is fully integrated with GLOBUS facilities such as Limits and Position management. In addition, Trading FRAs can be monitored via separate FRA positions.

Accounting in the FRA module is flexible; the user can exercise a level of control over FRA processing and Accounting rules.

Reports included with the module highlight transactions which remain unconfirmed, or due for rate fixing.

It is useful to make clear the definitions used in this document for the following:

• HEDGE

An FRA.DEAL booked by the bank to lock in a profit (or minimise a loss) to offset a Loan or Deposit contract on the banks’ books.

• TRADE

A speculative deal which is booked and usually offset against an opposite contract which ‘closes’ the first deal.

FRA Purchases: • PROFIT

Where the settlement rate is HIGHER than the FRA.DEAL contract rate • LOSS

Where the settlement rate is LOWER than the FRA.DEAL contract rate FRA Sales:

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12.2 FRA.PARAMETER

Basic information for FRA processing is defined in the application FRA.PARAMETER. Each

COMPANY will have its own FRA.PARAMETER record; this allows FRA processing to be

specific to each business environment.

12.2.1 Future Rate Agreement Types

All FRAs must be classified as either Trade or Hedge on input. It is not possible to change the classification of a FRA. If a FRA is booked incorrectly, it must be reversed and re-input. Trading and Hedging FRAs are processed differently by GLOBUS. Trading FRAs are included in FRA.POSITIONS and these positions are revalued regularly according to the rules specified in FRA.PARAMETER. This profit/loss is booked as specified in FRA.PARAMETER. Hedging FRAs do not appear in FRA positions. They only make Profit or Loss at settlement, which is then accrued over the life of the contract.

FRA.PARAMETER contains Accounting and Processing rules: some of these are relevant to

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12.2.2 General processing information • Variance allowed for prices and interest

• Periodic Interest rate to measure interest variance against • Whether confirmations are matched by Broker & Counterparty • Number of days in advance for rate fixing & report production • Settlement formula used for each currency

12.2.3 Accounting information All Contracts

• Category codes for Brokerage expense • First/last day accrual

Trading FRAs

• Revaluation rates for Long/short positions & periods

• Category codes & rules for booking realised & unrealised P&L from revaluing FRA

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12.3 Inputting a FRA

FRA transactions are input via the application FRA.DEAL.

12.3.1 Basic Information

Many of the details required to input an FRA.DEAL are similar to those for a Money Market deal: • Counterparty • Principal (notional) • Currency • Rate • Commission • Brokerage

• Settlement details, etc

The field which is essential to FRA input is the FRA.TYPE. This specifies whether the deal is a

TRADE or a HEDGE. FRA.DEAL will not accept input of a transaction unless the FRA.TYPE is

specified, as this tells the module how to process the accounting for the deal. The following screens show the input fields for a trade deal:

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Figure 12-4 FRA.DEAL - 2nd screen

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12.3.2 Additional Information

Additional information for FRA contracts is needed because there is a second stage of input -on Rate fixing date the prevailing rate should be input so the settlement amount can be calculated. Rate fixing date is taken to be the deal start date. The following table summarises the main dates for FRA events:

Deal event LCY FCY, if different

Trade date Today or earlier

Spot date ≡ Trade date Trade date + 2

Start date Spot date + period (1)

Rate fixing date ≡ Start date Start date - 2 Maturity date Start date + period (2)

Table 12-1 Main event dates

A number of rates are input on a FRA. Key rates are the INTEREST.RATE - the rate agreed

when the FRA is input and the SETTLEMENT.RATE the prevailing rate on rate fixing date. The

difference between these two rates determines the settlement amount. In addition, the

REFERENCE.RATE and REFERENCE.PRICE are used to for tolerance checking.

12.3.3 Related Deals

Both Hedging and Trading FRA contracts may have related deals.

Hedge transactions must, by definition, be hedging another deal. You can track this by entering the deal id in HEDGE.TRANS.ID.

Trade FRAs may be closing an existing FRA position for profit taking. The

POSN.OPEN.CLOSE flag indicates whether a trade opens or closes a position. The CLOSED.FRA.IDS shows which FRAs have been closed out.

Finally, a FRA may be replacing an earlier deal which has been reversed and re-input. For instance, if a trade has been erroneously input as a hedge, it must be backed out and re-input to make sure that all the accounting entries made so far are removed. The field

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12.4 FRA positions 12.4.1 Position Definition

The FRA module automatically updates Position Management, but in addition a separate FRA position file is maintained. FRA.POSITION contains position information about all ‘Trade’ contracts. (‘Hedge’ transactions usually remove a position or risk for the bank, and so are not included in this file.)

FRA positions are held by currency, dealer desk and period. Each position records information about the deals which make up the position, in addition to combined and profit data.

For an explanation of how positions and profit are calculated, see the section ‘FRA Formulae’ later in this chapter.

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12.4.2 Information held

For each FRA position you can see:

• Current position, position at start of business today, cost of position

• Profit realised today from FRA closures. Closure profit from previous days, and from backvaluations

• Revaluation of total open position

Each position also keeps information about constituent deals. Trades done today are kept separate from previous business, but the following information is stored for both:

• Deal id • Trade date • Principal • FRA rate • Profit, if closed.

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12.5 FRAs and Limits

FRAs are not subject to a centralised exchange regulatory authority or to a centralised clearing body to act as guarantor. As a result FRAs carry counterparty credit risk; that is there is a risk that monies due for payment from one party to another will not be forthcoming. As principal is never exchanged, exposure to credit risk is limited to the actual payments, ie interest variation. Thus the potential credit risk is dependant upon the volatility of interest rates. You can monitor this “reduced” risk by defining a percentage risk on the

LIMIT.REFERENCE file for the FRA products.

Limits apply to both Hedging and Trading FRAs and to both sales and purchases. The exposure will be liquidated at deal start, rather than deal maturity, as settlement is on deal start date.

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12.6 FRA Position Management Interface

The FRA application is fully integrated within the Position Management (PM) facility. All updates will take place at time of first input after successful validation.

The following rules apply for the interface to the various components of the PM module:

12.6.1 Cash-Flow/Liquidity

For both trade and hedge contracts, from the input of the FRA contract, until the rate fix date each ‘end of day’ a projected cash-flow is calculated, using the PERIODIC.INTEREST table, similar to the Trade contract revaluation process. This figure is passed each day to the cash-flow enquiry until rate fix date, when the projected figure is replaced by the ‘true’ value.

On rate fixing day, as determined by the FRA.PARAMETER Table, but which is normally for foreign currency two days before, and for local currency equal to settlement date, the settlement amount is calculated, and the resulting profit ("IN") or loss ("OUT") will be included in the cash flow under the settlement value date.

12.6.2 Interest Gap

Only "hedging" contracts are included and feed the PM module. The REFERENCE.PRICE on the FRA.DEAL contract is used for the LONG period rate. The SHORT period rate is calculated according to the standard formula.

12.6.3 FX Position

The standard FX position call is done within the accounting process, whenever entries impact the foreign exchange position. This will be the case for example on:

• Foreign currency charges & commission

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12.7 FRA Accounting

This module has been designed to give a high level of flexibility in accounting for FRA transactions. Many accounting decisions are controlled by the user, by defining the appropriate values on the FRA.PARAMETER table. For example, this is where you can decide whether to book unrealised profit, whether to recognise realised profit on trade date or FRA start date, to make customer charges on trade or start date etc.

FRA.PARAMETER should be set up to reflect your business environment. FRA accounting

must also reflect the results of management decisions: different rules will apply if a contract is classified as a Hedge or a Trade.

12.7.1 Specific rules for Trade Deals Entries are raised at the following times:

• End of day when ‘closure deals’ are input, or deals are reversed • Revaluation time

• Settlement date

Profit entries can be raised:

• Realised profit can either be posted on trade date or deal start date • Unrealised profit can either be posted, or not posted.

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12.7.2 General FRA rules

1. Positions (both total and contract level) are reversed each day and re-posted. Even if the posting leaves the figures unchanged. This is far easier for audit purposes than adjustments.

2. At the end of each day, the adjustments to the profit and loss for ‘closed’ trades are posted. This P&L is taken as realised Profit or Loss. This adjustment can be split into two -today’s P&L and an adjustment to yesterday’s figure. Each part is processed separately. A net P&L amount is kept on the FRA.POSITION file. If this is Profit, daily entries are processed according to ‘Profit’ accounting rules.

3. The net open position (ie total position rather than deal-by-deal) is also revalued. Any previous revaluation is reversed, and the new revaluation is posted as unrealised P&L. 4. When rate fixing date is reached, the position P&L entries are reversed out and booked to

the individual deals.

5. Between rate fixing date and settlement (start) date, the P&L for each deal is reversed and recalculated daily to keep the posted P&L converging to the settlement amount.

6. On settlement date, the deal P&L is again reversed, and the actual settlement amount posted as realised P&L.

7. When the total realised profit and loss figure changes from a loss to a profit (or vice versa), then the accounting entries will bring the loss category to zero and raise the profit position (or vice versa).

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12.7.3 Accounting entries on deal date - all contracts

Recognition of the FRA contract by the creation of a contingent CRF record. This will be reported as an off-balance sheet item:

Charges/commissions, taxes on commission/charges and brokerage will be booked on Deal date if so defined on the FRA.PARAMETER table. Otherwise they will be booked on the settlement date of the FRA contract. The entries will be identical only the timing is different.

Accounting type DR/CR Details CONTINGENT (CRB) DR

CR

SALE - (Notional Principal) PURCHASE - (Notional Principal)

BROKERAGE DR CR P&L - (FRA.PARAMETER) BROKER - (ACCOUNT.CLASS) CHARGES/COMMISSION CR DR P&L - FT.CHARGES

CUSTOMER A/C - (CONTRACT)

Table 12-2 Deal date accounting

12.7.4 Accounting entries from trade date to rate fixing

12.7.4.1 Open trade contracts

Between deal date and rate fixing date, for trade contracts only, revaluation takes place determined by the frequency specified in the FRA.PARAMETER, with the resulting profit or loss optionally booked or not to unrealised profits. Again this is determined by the field

BK.UR.PFT in FRA.PARAMETER input. See the FRA.PARAMETER helptext for a more

detailed explanation of the options on profit/loss booking.

The revaluation is based on the net FRA.POSITION by currency until rate fixing day, from whence the deals are re-valued individually until settlement day. Each new revaluation will result in the previous day’s calculation being reversed, and the updated figure being posted to the internal asset or liability account.

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12.7.4.2 Closed trade contracts

Profit or Loss for Closed contracts is ‘locked in’ when the closing trade is made. According to the setting of REAL.PFT.T/S in FRA.PARAMETER this realised Profit can either be taken

on trade date, or on settlement date.

If Profit is to be taken on Trade date, the following additional postings are made on Trade date;

Accounting type DR/CR Details

PROFIT CR

DR

P&L - (FRA.PARAMETER)

INTERNAL ASSET A/C - (FRA.PARAMETER)

LOSS DR

CR

INTERNAL LIAB A/C - (FRA.PARAMETER)

Table 12-4 ACCOUNT for posting Profit

There are no revaluation entries between Trade date and Rate setting date for Closed trades, as the Profit from the contracts cannot change.

If the Profit is to be taken on Settlement date, the above entries will only be made in the case of closing out a Loss. If the closure has made a Profit, no entries will be made to reflect this until settlement date, when the money is actually received from the counterparty.

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12.7.5 Rate fixing

At Rate fixing date, the Profit or Loss for all contracts in the position is known. Up till now, all P&L postings have been net for the total position. This net Position P&L is reversed out:

PROFIT DR

CR

LOSS CR

DR

Table 12-5 Reversing the position postings

and replaced by individual realised P&L postings for each trade: Accounting type DR/CR Details

PROFIT CR

DR

LOSS DR

CR

Table 12-6 Postings for each trade

(Unless realised profit is deferred till settlement date, in which case no entries are made for trades in profit until then.)

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12.7.6 Accounting entries on settlement date - trade contracts

On settlement date the profit or loss entries are generated as appropriate, with the offset to customer or nostro.

Existing off balance sheet accounting entries (reporting the deal as contingent) are removed by application of the opposite accounting entries.

PROFIT CR DR -OR-P&L - (FRA.PARAMETER) CUSTOMER/NOSTRO LOSS DR CR P&L - (FRA.PARAMETER) CUSTOMER/NOSTRO CONTINGENT (CRB) CR DR

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12.7.7 Accounting entries on settlement date - hedge contracts

The amount to be paid or received by the bank on settlement day will be deferred to an internal asset or liability account (IPIA/IRIA), and appropriated to profit and loss over the fixed rate period, (i.e. from settlement to maturity date) on a straight line basis.

PROFIT CR DR -OR-* IRIA - (FRA.PARAMETER) CUSTOMER/NOSTRO LOSS DR CR * IPIA - (FRA.PARAMETER ) CUSTOMER/NOSTRO CONTINGENT (CRB) CR DR

Table 12-8 Settlement date accounting - hedge contracts

*Daily amortising of Profit or Loss to P&L from Settlement to Maturity Date

PROFIT DR CR -OR-* IRIA - (FRA.PARAMETER) P&L (FRA.PARAMETER) LOSS CR DR * IPIA - (FRA.PARAMETER) P&L (FRA.PARAMETER)

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12.7.8 Accounting entries on late settlement date - trade contracts

In the event of late rate fixing of trade contracts, entries are booked to P&L as normal, with the offset to suspense accounts. The handling of the payment or receipt of funds is a manual activity, after consultation with the counterparty.

PROFIT CR

DR -OR

* SUSPENSE A/C (ACCOUNT.CLASS)

LOSS DR

CR

* SUSPENSE A/C (ACCOUNT.CLASS) CONTINGENT (CRB) CR

DR

Table 12-10 Accounting on late settlement trade contracts

*Manual entry to clear SUSPENSE A/C and Pay or Receive funds

PROFIT DR

CR -OR

CUSTOMER/NOSTRO

LOSS CR

DR

CUSTOMER/NOSTRO

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12.7.9 Accounting entries on late settlement date hedge contracts

In the event of late rate fixing of hedge contracts, entries are booked to P&L as normal, with the offset to suspense accounts. The handling of the transfer to an internal asset/liability account is handled manually.

From the internal account, the profit or loss is dripped to P&L over the life of the contract i.e. from settlement to maturity date.

PROFIT CR

DR

IRIA - (FRA.PARAMETER)

*SUSPENSE A/C (ACCOUNT.CLASS)

LOSS DR

CR

IPIA - (FRA.PARAMETER)

*SUSPENSE A/C (ACCOUNT.CLASS) CONTINGENT

(CRB)

CR DR

Table 12-12 Late settled hedge contract accounting

*daily amortising of P&L

PROFIT DR CR IRIA - (FRA.PARAMETER) P&L - (FRA.PARAMETER) LOSS CR DR IPIA - (FRA.PARAMETER) P&L - (FRA.PARAMETER)

Table 12-13 Interest accruals

PROFIT DR

CR

CUSTOMER/NOSTRO

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12.8 FRA Reports

The following reports are released with this module:

Report Description

FRA.REVAL _{FRA positions revalued} FRA.HEDGE.DEALS _{List of outstanding hedges} FRA.MTH.ACCRUALS _{Accruals on hedge deals}

FRA.RATE.SETTING.REPORT _{FRAs where rate has to be fixed soon (as specified on} FRA.PARAMETER)

FRA.OVERDUE.REPORT _{FRAs where start date has passed, but rate not fixed} OUTSTANDING.FRAS _{List of all ‘live’ transactions}

UNFIXED.FRAS _{FRAs where rate not fixed yet}

CUS.UNCONFIRMED.FRAS _{List of FRAs still to be confirmed by the counterparty} BROK.UNCONFIRMED.FRAS _{List of FRAs still to be confirmed by the broker} FRA.REALISED.PL.REPORT _{P&L breakdown for each position}

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12.9 FRA calculations

The FRA revaluation involves:

1. Future Rate Calculation; and 2. FRA Valuation.

12.9.1 Future Rate Calculation

The future rate calculation is best illustrated by the diagram below.

Assuming there are two futures contracts on the market with quoted rates R1 and R3, covering the period from Spot to FRA Start and from Spot to Maturity respectively, the formula to calculate the forward rate R2 is as follows:

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)

Nominal R D B R D D B Nominal R D B * * * * * * * * * 1 1 1 100 1 2 3 1 100 1 3 3 100 +    + −     =  +  where

R1 = rate for short period (the period between Spot and FRA Start) D1 = number of days in short period

R3 = rate for long period (the period between Spot and Maturity) D3 = number of days in long period

B = interest day basis

Today Spot _Maturity

R3

R2 R1

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Simplifying the above formula gives: 1 2 3 1 100 1 3 3 100 1 1 1 100 2 1 3 3 100 1 1 1 100 1 100 3 1 2 100 3 3 100 1 1 100 1 1 100 3 1 2 3 + − = +_ _ _ + _ = + + −           − = + − + +    _ ₋ = ( * ( )) * * * * * * * * * * * * ( * ) ( * ( * )) * ( * ) * * ( R D D B R D B R D B R R D B R D B B D D R B R D B R D B R D B D D R R * ) ( * )* * ( * ) ( * ) ( * ) ( * ) * * D R D D D B B R D R R D R D D D R D B 3 1 1 3 1 100 100 1 1 2 3 3 1 1 3 1 1 1 100 1 − − + = − − +   

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Example

Today is August 8th 1996 (spot date 10th August 1996) and we wish to revalue an existing contract.

Contract = Purchase USD 250,000,000.00 FRA 1 against 4. Contract rate = 9.40

Start date = 20 Sept 1996 Maturity date = 20 Dec 1996

R1 = Periodic rate from 10 Aug to 20 Sept = 9.40

R3 = Period rate from 10 Aug to 20 Dec = 9.45

These rates are found or, when necessary, interpolated from the PERIODIC.INTEREST rate table.

D1 = No of days between 10 Aug and 20 Sept = 41 days

D3 = No of days between 10 Aug and 20 Dec = 132 days

(Note that number of days is always calculated from the spot date) Substituting in the above formula we find:

(

) (

)

R2 9 45 132 9 40 41 132 41 9 40 41 360 100 1 = × − × − × ×    +     . . .

(

) (

)

= −    +     1 247 40 385 40 91 385 40 36000 1 , . . . 862

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12.9.2 FRA Valuation

The Profit/Loss of a FRA contract is:

(

)

Profit.or.Loss Nominal Mkt Rate Deal Rate NDays B

= * . − . *

*100

where

Nominal = nominal amount of FRA deal Mkt.Rate = market rate

Deal.Rate = rate on FRA deal

NDays = number of days in FRA deal B = interest day basis

Since the FRA contract is settled up-front the formula for the present value of the Profit/Loss is as follows:

Present.Value Profit.or.Loss Mkt Rate NDays

B

Present.Value Nominal NDays Mkt Rate Deal Rate

B Mkt Rate NDays = + = − + 1 100 100 . * * * * ( . . ) ( * ) ( . * )

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Example

Position & Profit calculation: example using above formula 1) Purchase 100M GBP FRA, 3 against 6 at 9%

100M GBP FRA, 3 against 6 at 9.5%

Gives a Position of 200M GBP at 9.25%

2) Then Sell 50M GBP FRA, 3 against 6 at 9.5% Profit

(

)

(

)

[

]

(

)

P= − × × + × 9 5 9 25 91 50 000 000 36000 9 50 91 . . , , .

Therefore there is a profit of 0.25 at 50 million for 3 months 3) Then Sell 200M GBP FRA, 3 against 6 at 9.6%

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12.9.3 Calculation of Settlement Amount

The settlement amount for an existing FRA is calculated using:

(

) (

)

(

)

S I F N P B I N = − × × ×100+ ×

Figure 12-9 Settlement formula

where

I = prevailing rate at rate fixing date, eg LIBOR F = FRA rate (deal rate)

N = Number of days in deal P = Principal

B = Basis for currency

To settle the contract in the first example, i.e. a purchase of 1 against 4 FRA for 250M USD at 9.4%, when LIBOR is at 9.37%;

(

) (

)

(

)

S= − × × × + × 9 37 9 40 91 250 000 000 360 100 9 37 91 . . , , .

(

)

(

)

(

)

= − × + 0 03 22 750 000 000 36000 852 67 . , , , . = -18,519.69

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Index of Tables & Figures

Table 12-1 Main event dates ...12-6 Table 12-2 Deal date accounting ...12-13 Table 12-3 ACCOUNT for posting Profit ...12-13 Table 12-4 ACCOUNT for posting Profit ...12-14 Table 12-5 Reversing the position postings ...12-15 Table 12-6 Postings for each trade...12-15 Table 12-7 Settlement date accounting - trade contracts ...12-16 Table 12-8 Settlement date accounting - hedge contracts ...12-17 Table 12-9 Daily accrual of interest ...12-17 Table 12-10 Accounting on late settlement trade contracts ...12-18 Table 12-11 Manual accounting entries...12-18 Table 12-12 Late settled hedge contract accounting...12-19 Table 12-13 Interest accruals ...12-19 Table 12-14 Manual accounting entries...12-19 Table 12-15 FRA reports ...12-20 Figure 12-1 FRA.PARAMETER - Defining major processing characteristics...12-2 Figure 12-2 FRA.PARAMETER - second screen ...12-3 Figure 12-3 FRA.DEAL - opening a trading position ...12-4 Figure 12-4 FRA.DEAL - 2nd screen...12-5 Figure 12-5 FRA.DEAL - 3rd screen ...12-5 Figure 12-6 FRA.POSITION - for USD, Dealer desk 01, period Feb 8th - April 7th...12-7 Figure 12-7 FRA future rate calculation formula...12-22 Figure 12-8 FRA valuation formula...12-24 Figure 12-9 Settlement formula...12-26