Forward rate agreement (FRA) is a financial contract that allows parties to secure a future interest rate on a specified date for an agreed-upon amount. In this article, we`ll discuss what FRAs are, how they work, and why companies and investors use them.

What is a Forward Rate Agreement?

A Forward Rate Agreement (FRA) is a financial contract between two parties that allow them to secure a future interest rate on a specified date for an agreed-upon amount. An FRA is a derivative instrument that is used to hedge against interest rate risks.

FRAs are typically used by borrowers and lenders to manage their interest rate exposure. For example, if a borrower is planning to take out a loan in the future, but they are concerned about interest rates rising, they may enter into an FRA contract with a lender, which guarantees them an interest rate that they can use to calculate their borrowing costs in the future.

How do FRAs work?

An FRA contract works by agreeing on a future interest rate that will be used to calculate the interest owed or earned on a specified amount of money on a future date. The FRA contract specifies the start date, end date, and notional amount of the agreement.

For example, let`s say a borrower anticipates the interest rate on a loan they plan to take out in six months to be 7.5%. They enter into an FRA contract with a lender for a notional amount of $100,000, with the start date in six months, and the end date in twelve months. The FRA contract specifies a forward interest rate of 7.5%.

If the interest rate on the loan is above 7.5%, the borrower will receive a payment from the lender equal to the difference between the contract rate and the actual rate. On the other hand, if the interest rate is below 7.5%, the borrower will have to pay the lender the difference between the contract rate and the actual rate.

Why do companies and investors use FRAs?

FRAs are commonly used by companies and investors to hedge against adverse interest rate movements. By entering into an FRA contract, they can lock in a future interest rate, which can provide certainty in planning future cash flows.

FRAs can be particularly useful in situations where interest rate movements are difficult to predict, such as in a volatile market or a changing economic environment. By using an FRA, companies and investors can reduce their exposure to interest rate risk and protect their profits.

Conclusion

In conclusion, Forward Rate Agreements (FRAs) are a financial contract that allows parties to secure a future interest rate on a specified date for an agreed-upon amount. They are commonly used by borrowers and lenders to manage their interest rate exposure and provide certainty in planning future cash flows. FRAs can be useful in situations where interest rate movements are difficult to predict, providing companies and investors with a tool to reduce their exposure to interest rate risk and protect their profits.