Loading the player...

What is a 'Forward Rate Agreement (FRA)'

Forward rate agreements (FRA) are an over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. 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 and the reference rate in the contract. The notional amount is not exchanged.

Breaking Down the 'Forward Rate Agreement (FRA)'

Forward rate agreements involving  interest rates typically see two parties exchange 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.

As a basic example, assume Company A enters into an FRA with Company B in which Company A will receive a fixed rate of 5% for one year on a principal 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.

Forward Rate Agreement Payment Formula

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

The FRA payment amount is calculated by multiplying two terms together, the settlement amount and the discount factor:

FRA payment = (((R - FRA) x NP x P) / Y) x (1 / (1 + R x (P / Y)))

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 = (((4% - 3.5%) x $5,000,000 x 181) / 360) x (1 / (1 + 4% x (181 / 360))) = $12,569.44 x 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. As for the day-count convention, if the contract is in British sterling, 365 days are used. In all other currencies the convention is to use 360 days.

The notional amount of $5 million is not exchanged. Rather the two company involved in this transaction are using that figure to calculate the interest rate differential.

RELATED TERMS
  1. Frankfurt Stock Exchange (FRA) ...

    Located in Frankfurt, Germany, the FRA is one of the largest ...
  2. Covered Interest Arbitrage

    Covered interest arbitrage is a strategy where an investor uses ...
  3. Notional Principal Amount

    The notional principal amount, in an interest rate swap, is the ...
  4. Notional Value

    Notional value is the total value of a position, or how much ...
  5. Forward Discount

    A forward discount occurs when the expected future price of a ...
  6. Currency Forward

    A binding contract in the foreign exchange market that locks ...
Related Articles
  1. Retirement

    Work & Collect Social Security in Retirement?

    What to consider if working in retirement while collecting Social Security.
  2. Retirement

    The Economics of Raising the Social Security Age

    Briefly examine the economics behind raising the retirement age for Social Security benefits and how it could impact the federal budget.
  3. Managing Wealth

    Managing interest rate risk

    Interest rate risk is the risk that arises when the absolute level of interest rates fluctuate and directly affects the values of fixed-income securities.
  4. Retirement

    The Top 5 Social Security Mistakes to Avoid

    Social Security claiming strategies can be complex. Be sure to avoid these mistakes.
  5. Retirement

    Social Security Retirement Benefits Basics

    Understand Social Security benefits, including how to qualify, how benefits are calculated, when you should start claiming them, and spousal benefits.
  6. Retirement

    Helping Couples Strategize for Social Security

    Even with the elimination of the file-and-suspend option for couples claiming Social Security, there are strategies they can use to maximize benefits.
  7. Retirement

    3 Reasons to Postpone Collecting Social Security

    There are many benefits to delaying receiving Social Security until you are 70.
  8. Financial Advisor

    File and Suspend is Done: Now What for Spousal Benefits?

    The popular file and suspend strategy for couples claiming Social Security has been eliminated, but spousal benefits remain an option in some cases.
  9. Financial Advisor

    How Working Longer Impacts Social Security

    A look at the impact of working longer on Social Security retirement benefits.
  10. Financial Advisor

    Clearing Up 7 Big Social Security/Medicare Myths

    Here are some common misconceptions that many clients of financial advisors have when it comes time to file for Social Security and Medicare.
Hot Definitions
  1. Current Assets

    Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
  2. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  3. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  4. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
  5. Depreciation

    Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account ...
  6. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained in a company’s financial statements.
Trading Center