Forward Rate Agreements (FRAS)

Forward rate agreements (FRA) are over-the-counter contracts between parties that determine the rate of interest to be paid on an agreed-upon date in the future. In other words, an FRA is an agreement to exchange an interest rate commitment on a notional amount.

The FRA determines the rates to be used along with the termination date and notional value. FRAs are cash-settled. The payment is based on the net difference between the interest rate of the contract and the floating rate in the market the reference rate. The notional amount is not exchanged. It is a cash amount based on the rate differentials and the notional value of the contract.

In finance, a forward rate agreement (FRA) is an interest rate derivative (IRD). In particular it is a linear IRD with strong associations with interest rate swaps (IRSs).

Steps:

• Calculate the difference between the forward rate and the floating rate or reference rate.
• Multiply the rate differential by the notional amount of the contract and by the number of days in the contract. Divide the result by 360 (days).
• In the second part of the formula, divide the number of days in the contract by 360 and multiply the result by 1 + the reference rate. Then divide the value into 1.
• Multiply the result from the right side of the formula by the left side of the formula.

Uses and Risks

Many banks and large corporations will use FRAs to hedge future interest or exchange rate exposure. The buyer hedges against the risk of rising interest rates, while the seller hedges against the risk of falling interest rates. Other parties that use Forward Rate Agreements are speculators purely looking to make bets on future directional changes in interest rates. The development of swaps in the 1980s provided organisations with an alternative to FRAs for hedging and speculating.

In other words, a forward rate agreement (FRA) is a tailor-made, over-the-counter financial futures contract on short-term deposits. A FRA transaction is a contract between two parties to exchange payments on a deposit, called the Notional amount, to be determined on the basis of a short-term interest rate, referred to as the Reference rate, over a predetermined time period at a future date. FRA transactions are entered as a hedge against interest rate changes. The buyer of the contract locks in the interest rate in an effort to protect against an interest rate increase, while the seller protects against a possible interest rate decline. At maturity, no funds exchange hands; rather, the difference between the contracted interest rate and the market rate is exchanged. The buyer of the contract is paid if the published reference rate is above the fixed, contracted rate, and the buyer pays to the seller if the published reference rate is below the fixed, contracted rate. A company that seeks to hedge against a possible increase in interest rates would purchase FRAs, whereas a company that seeks an interest hedge against a possible decline of the rates would sell FRAs.

Forward Rate Agreement = R2 + (R2 – R1) x [T1 / (T2 – T1)]

Forward rate agreements typically involve two parties exchanging a fixed interest rate for a variable one. The party paying the fixed rate is referred to as the borrower, while the party paying the variable rate is referred to as the lender. The forward rate agreement could have the maturity as long as five years.

A borrower might enter into a forward rate agreement with the goal of locking in an interest rate if the borrower believes rates might rise in the future. In other words, a borrower might want to fix their borrowing costs today by entering into an FRA. The cash difference between the FRA and the reference rate or floating rate is settled on the value date or settlement date.