Derivatives - Characteristics of Forward Rate Agreements (FRAs)


An FRA is a contract in which the underlying rate is simply an interest payment, not a bond or time deposit, made in dollars, euribor or any other currency at a rate that is appropriate for that currency. A forward rate agreement is a forward contact on a short-term interest rate, usually LIBOR, in which cash flow obligations at maturity are calculated on a notional amount and based on the difference between a predetermined forward rate and the market rate prevailing on that date. The settlement date of an FRA is the date on which cash flow obligations are determined.

  • The structure is the same for all currencies.
  • FRAs mature in a certain number of days and are based on a rate that applies to an instrument maturing in a certain number of days, measured from the maturity of the FRA.
  • The structure is as follows: The short party or dealer and the long party or end-user will agree on an interest rate, a time interval and a "hypothetical" contract amount. The end-user benefits if rates increase (she has locked-in a lower rate with the dealer). Because the end-user is long, the dealer must be short the interest rate and will benefit if rates decrease.
  • The contact covers a notional amount but only interest rate payments on that amount are considered.
  • It is important to note that even though the FRA may settle in fewer days than the underlying rate (i.e. the number of days to maturity in the underlying instrument), the rate that the dealer quotes has to be evaluated in relation to the underlying rate.
  • Because there are two-day figures in the quotes, participants have come up with a system of quotes such as 3 x 9, which means the contract expires in three months and in six months, or the nine months from the formation of the contract, interest will be paid on the underlying Eurodollar time deposit upon which the contract's rate is based.
  • Other examples include 1 x 3 with the contract expiring in one month based on a 60-day LIBOR, or 6 x 12, which means the contract expires in six months based on the underlying rate of a 180 day LIBOR.
  • Usually based on exact months such as 30 day LIBOR or 60 day LIBOR not 37 days and 134 day LIBOR. If a client wants to tailor an FRA, it is likely that a dealer will do it for the client. When this occurs, it is considered to bean off-the-run contract
  • The best way to see it is through an example, which we will cover in the next section.

Calculation of Payment at Expiration of FRA
Let's set up the transaction:

  • Dealer quotes a rate of 4% on this instrument and end user agrees. He is hoping that rates will increase.
  • Expiration is in 90 days.
  • The notional amount is $ 5 million.
  • The underlying interest rate is the 180 LIBOR time deposit.
  • In 90 days the 180-day LIBOR is at 5%. That 5% interest will be paid 180 days later.

So: 5,000,000 x ((0.05 - 0.04) (180/360)) = $ 47,600
                                      1 + 0.05 (180/360)

Because rates increased, the long party or the end user will receive $47,600 from the short party or the dealer.

If the rates were to decrease, the long party or the end user would have to pony up a payment that would be the difference between the quoted rate and the 180-day LIBOR rate.

In written terms, the formula looks like this for the party going long:

Formula 16.1
((Underlying rate at expiration - Forward contract rate)(days in underlying rate/360))
1 + underlying rate (days in underlying rate/360)


  • Forward contract rate = rate the two parties agree will be paid
  • Days in underlying rate = number of days to maturity on the underlying instrument

In the numerator, we see that the contract is paying the difference between the actual rate that exists in the marketplace on the expiration date and the agreed-upon rate at the beginning of the contract. It is adjusted for the fact that the rate applies to a 180-day rate multiplied by the notional amount.

The divisor is there because when the rates are quoted in the market, they are based on the assumption that they will accrue interest, which will be paid at a certain time. So the FRA payoff needs to be adjusted to reflect the fact that the rate implies a payment that will occur in the future, say 180 days using our above example. Discounting the payment at the current LIBOR does the adjustment.

Currency Forward Contracts
Related Articles
  1. Financial Advisors

    Tips on Passing the CFA Level I on Your First Attempt

    Obtain valuable tips and helpful study instructions that can help you pass the Level 1 Chartered Financial Analyst exam on your first attempt.
  2. Financial Advisors

    Putting Your CFA Level I on Your Resume

    Learn techniques for emphasizing your CFA Level I status in the Skills and Certifications or Professional Development section of your resume.
  3. Professionals

    Investment Analyst: Career Path and Qualifications

    Learn how to prepare for a career as an investment analyst, and read more about how many professionals in the field progress during their careers.
  4. Professionals

    CAIA Vs. CFA: How Are They Different?

    Find out how the CAIA and CFA designations differ, including which professionals should seek either title based on their career ambitions.
  5. Professionals

    Equity Investments: CFA Level II Tutorial

    Chapter 1: Equity Valuation: Its Applications and Processes Chapter 2: Return Concepts for Equity Valuation Chapter 3: Industry Analysis With Porter's 5 Forces
  6. Professionals

    What To Expect On The CFA Level III Exam

    The Chartered Financial Analyst Level III exam, which is only offered in June, is the last in the series of three tests that CFA candidates must pass.
  7. Professionals

    What To Expect On The CFA Level I Exam

    Becoming a chartered financial analyst requires the passing of three grueling exams covering an array of topics.
  8. Options & Futures

    The Alphabet Soup of Financial Certifications

    We decode the meaning of the many letters that can follow the names of financial professionals.
  9. Professionals

    How to Ace the CFA Level I Exam

    Prepare to ace the CFA Level 1 exam by studying systematically.
  10. Personal Finance

    How To Choose A Financial Advisor

    Many advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Security Analyst

    A financial professional who studies various industries and companies, ...
  4. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  3. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  4. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  5. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  6. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
Trading Center