Will forward rate agreements (FRAs) be replaced before LIBOR is discontinued?

Replacing forward rate agreements (FRAs) with interest rate swaps may occur before LIBOR is permanently discontinued.

Steven Burrows, senior lawyer at Fieldfisher, comments: 

“Derivatives dealers may look to move away from “traditional” FRAs and towards “single period swaps” before LIBOR is discontinued in order to avoid incompatibilities between FRAs and the priority fall-backs that ISDA is proposing to incorporate in its 2006 Definitions.

FRAs traditionally pay out at the start of an interest period, rather than at the end, in order to mitigate credit risk. These products will not work as intended to the extent they are subject to ISDA’s priority fall-backs. Those fall-backs operate by deriving a synthetic version of LIBOR by following a two-step process. First, a term rate is derived by compounding the relevant risk-free rate (RFR) in arrears over the relevant interest period. A spread is then applied to add back the credit risk component embedded in LIBOR based on historic spreads between LIBOR and the corresponding RFR. The synthetic LIBOR, and therefore the cash flow, is only determinable at the end of the interest period.

This issue is not unique to FRAs and may also impact upon caps, floors and collars (i.e., any interest rate derivatives that pay out at the start of interest periods).

Interest rate swaps, on the other hand, differ from FRAs in this regard as they typically pay out at the end of each interest period. However, an interest rate swap can be thought of as a back-to-back chain of FRAs, with each FRA representing a single interest period. A “single period swap” is therefore simply an interest rate swap with a single period and would be equivalent to a FRA, albeit it would pay out at the end of the interest period. These swaps would then be compatible with ISDA’s priority fall-backs whilst being economically similar to a FRA.”

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