What Is a Forward Rate Agreement (FRA)?
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. 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 with the payment based on the net difference between the interest rate of the contract and the floating rate in the market called the reference rate. The notional amount is not exchanged, but rather a cash amount based on the rate differentials and the notional value of the contract.
Forward Rate Agreement
FRA Payment=(Y(R−FRA)×NP×P)×(1+R×(YP)1)where:FRA=Forward rate agreement rate, or fixed interest rate that will be paidR=Reference, or floating interest rate used in the contractNP=Notional principal, or amount of the loan that interest is applied toP=Period, or number of days in the contract periodY=Number of days in the year based on the correct day-count convention for the contract
- 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. The divide the value into 1. Multiply the result from the right side of the formula by the left side of the formula.
What the Agreement Means
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 receiving the variable rate is referred to as the lender. The forward rate agreement could have a 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.
For example, if the Federal Reserve Bank is in the process of hiking U.S. interest rates, called a monetary tightening cycle, corporations would likely want to fix their borrowing costs before rates rise too dramatically. Also, FRAs are very flexible, and the settlement dates can be tailored to the needs of those involved in the transaction.
- 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.
- The notional amount is not exchanged, but rather a cash amount based on the rate differentials and the notional value of the contract.
- A borrower might want to fix their borrowing costs today by entering into an FRA.
Example of an Agreement
Company A enters into an FRA with Company B in which Company A will receive a fixed rate of 5% on a principal amount of $1 million in one year. In return, Company B will receive the one-year LIBOR rate, determined in three years' time, on the principal amount. The agreement will be settled in cash in a payment made at the beginning of the forward period, discounted by an amount calculated using the contract rate and the contract period.
The formula for the FRA payment takes into account five different variables. They are:
- FRA = the FRA rate
- R = the reference rate
- NP = the notional principal
- P = the period, which is the number of days in the contract period
- Y = the number of days in the year based on the correct day-count convention for the contract
Assume the following data:
- FRA = 3.5%
- R = 4%
- NP = $5 million
- P = 181 days
- Y = 360 days
The FRA payment is calculated as:
FRA Payment=(360(.04−.035)×$5 million×181)×(1+.04×(360181)1)=$12,569.44×0.980285=$12,321.64
If the payment amount is positive, the FRA seller pays this amount to the buyer. Otherwise, the buyer pays the seller. The day-count convention is typically 360 days.
The notional amount of $5 million is not exchanged. Instead, the two companies involved in this transaction are using that figure to calculate the interest rate differential.
Forward Contracts (FWD)
A forward rate agreement is different than a forward contract. A currency forward is a binding contract in the foreign exchange market that locks in the exchange rate for the purchase or sale of a currency on a future date. A currency forward is a hedging tool that does not involve any upfront payment. The other major benefit of a currency forward is that it can be tailored to a particular amount and delivery period, unlike standardized currency futures.
The FWD can result in the currency exchange being settled, which would include a wire transfer or a settling of the funds into an account. There are times when an offsetting contract is entered, which would be at the prevailing exchange rate. However, offsetting a forward contract results in settling the net difference between the two exchange rates of the contracts. An FRA results in settling the cash difference between the interest rate differentials of the two contracts.
A currency forward settlement can either be on a cash or a delivery basis, provided that the option is mutually acceptable and has been specified beforehand in the contract.
There is a risk to the borrower if they had to unwind the FRA and the rate in the market had moved adversely so that the borrower would take a loss on the cash settlement. FRAs are very liquid and can be unwound in the market, but there will be a cash difference settled between the FRA rate and the prevailing rate in the market.