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Table of Contents
What is a Forward Rate Agreement (FRA)?
A Forward Rate Agreement (FRA) represents an over-the-counter financial contract that allows two parties to lock in an interest rate for a future period on a notional principal amount. FRAs are primarily used to hedge interest rate risk or speculate on future interest rate movements.
Definition
Forward Rate Agreement (FRA) is a derivative contract in which parties agree on an interest rate to be paid or received on a specified notional amount for a future time period.
Key Takeaways
- FRAs are used to manage exposure to future interest rate changes.
- They are settled in cash, with no exchange of principal.
- Commonly used by banks, corporations, and institutional investors.
Understanding Forward Rate Agreements
A forward rate agreement fixes the interest rate that will apply to a loan or deposit starting at a future date. When the contract period begins, the agreed rate is compared with the prevailing market reference rate, and a cash settlement occurs based on the difference.
Because FRAs are OTC instruments, they can be customized in terms of notional amount, duration, and reference rate. However, this flexibility also introduces counterparty risk.
FRAs are closely related to other interest rate derivatives such as interest rate swaps and futures, but they are typically shorter-term instruments.
Formula (If Applicable)
FRA Settlement Amount:
Settlement = Notional × (Reference Rate − FRA Rate) × (Days ÷ 360) ÷ (1 + Reference Rate × Days ÷ 360)
Real-World Example
A company expects to borrow funds in three months and fears rising interest rates. It enters into an FRA to lock in a fixed rate today. If market rates rise above the agreed rate, the FRA settlement offsets the higher borrowing cost.
Importance in Business or Economics
Forward rate agreements are important because they:
- Provide certainty over future borrowing or lending costs
- Support interest rate risk management
- Enhance efficiency in financial markets
They are widely used in treasury management and banking operations.
Types or Variations
Borrower FRA: Protects against rising interest rates.
Lender FRA: Protects against falling interest rates.
Related Terms
- Interest Rate Risk
- Interest Rate Swap
- Futures Contract
Sources and Further Reading
- Bank for International Settlements (BIS)
- International Swaps and Derivatives Association (ISDA)
- CFA Institute – Interest Rate Derivatives
Quick Reference
- OTC contract fixing a future interest rate.
- Cash-settled with no principal exchange.
- Used for hedging and speculation.
Frequently Asked Questions (FAQs)
Is an FRA the same as a futures contract?
No. FRAs are OTC and customized, while futures are standardized and exchange-traded.
Do FRAs involve actual loans?
No. They are cash-settled based on rate differences.
Who typically uses FRAs?
Banks, corporate treasuries, and institutional investors.
