What is Forward Rate Agreement ?

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A forward rate agreement (FRA) is an over-the-counter (OTC) contract between parties that determines the rate of interest to be paid on an agreed-upon date in the future. In other words, an FRA is an agreement to exchange an interest rate commitment on a notional amount.The forward rate agreement determines the rates to be used along with the termination date and notional value. FRAs are cash-settled. The payment is based on the net difference between the interest rate of the contract and the floating rate in the market—the reference rate. The notional amount is not exchanged. It is a cash amount based on the rate differentials and the notional value of the contract.

Definition

A Forward Rate Agreement (FRA) is a financial derivative instrument used to lock in an interest rate for a specific future period. It allows two parties to agree on an interest rate for a future period at the time of the agreement, to manage interest rate risk or for interest rate speculation.

Origin

FRAs originated in the 1970s as globalization of financial markets and increased interest rate volatility created a need for tools to hedge interest rate risk. The development of FRAs is closely linked to the expansion of interest rate futures and options markets.

Categories and Features

The basic features of an FRA include:
    1.    Parties involved: Typically borrowers and lenders, banks, or other financial institutions.
    2.    Notional amount: The virtual principal amount involved in the FRA, which is not actually exchanged, but interest is calculated based on this amount.
    3.    Agreement period: The time period specified in the agreement, usually indicated by a "start date" and an "end date."
    4.    Agreed rate: The interest rate agreed upon by both parties in the agreement.
    5.    Settlement date: Typically one day before the start date of the agreement, when settlement occurs.

Case Studies

Case 1: Suppose a large manufacturing company anticipates needing to borrow funds in six months but is concerned about rising interest rates. The company can enter into an FRA with a bank to lock in the current interest rate, thus avoiding additional costs from future rate increases.
Case 2: A bank expects a large deposit to mature in the future and wants to hedge against the risk of falling interest rates. The bank can use an FRA to lock in future interest rates, ensuring its deposit returns.

Common Issues

Common issues include:
1. Is an FRA suitable for all investors? Typically, FRAs are more suitable for large corporations and financial institutions needing to manage interest rate risk.
2. What are the main risks of an FRA? The main risks include market risk and credit risk, particularly the risk of counterparty default.

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