A Forward Rate Agreement, or FRA, is an agreement between two parties who want to protect themselves against future movements in interest rates. By entering into an FRA, the parties lock in an interest rate for a stated period of time starting on a future settlement date, based on a specified notional principal amount. The buyer of the FRA enters into the contract to protect itself from a future increase in interest rates. This occurs when a company believes that interest rates may rise and wants to fix its borrowing cost today. The seller of the FRA wants to protect itself from a future decline in interest rates. This strategy is used by investors who want to hedge the return obtained on a future deposit.
FRAs are settled using cash on the settlement date. This is the start date of the notional loan or deposit. The exposure to each counterparty is determined by the interest rate differential between the market rate on settlement date and the rate specified in the FRA contract. There are no principal flows.
The FRA is a very flexible instrument and can be tailored to meet the needs of both the buyer and seller to protect themselves against the volatility of interest rates which affect their future borrowings or investments. The principle advantages of FRAs are:
- Contracts can be structured to meet the specific needs of the user;
- Counterparty exposure is limited to the interest rate differential between the market rate and the contract rate;
- Administration costs are minimized as there is only one cash flow on the settlement date as opposed to daily futures settlement;
- They are off-balance sheet items; and
- They can easily be reversed or closed out using an offsetting FRA at a new price.
rc = FRA contract rate
rm = market rate
npa = notional principal amount
dt = maturity date of underlying FRA contract
de = settlement date of FRA contract
year_basis = number of days in year for particular accrual method
S = settlement amount