What Is a Forward Rate Agreement (FRA)?

What Is a Forward Rate Agreement (FRA)?

Let me explain what a forward rate agreement, or FRA, really is. It's an over-the-counter contract between two parties, with an interest rate as the underlying asset. In this setup, the long side commits to paying a fixed interest rate on a specified amount at a future date, while the short side pays based on a floating interest rate index for the same amount and date. The typical duration matches one interest rate period, like 90 days, but you and your counterparty can agree on any length that suits you.

FRAs give you a direct look into market expectations for future interest rates. Unlike implied forwards derived from current trading, FRAs are traded outright, showing exactly where participants think rates are going. At heart, these are derivative contracts valued on an interest rate index. When you start an FRA, its value is zero, and no premium changes hands. The fixed rate reflects the market's consensus on where the rate will land at maturity, making FRAs useful for checking sentiment and managing rate risk. If you're a business or investor, locking in that rate protects you from shifts.

Key Takeaways

You should know that FRAs are OTC contracts setting the interest rate for a future date. They're not standardized like exchange-traded products; instead, they're custom agreements with interest rates as the underlying. No notional amount gets exchanged—it's all cash settled based on rate differences and the contract's value. Borrowers use them to fix future borrowing costs.

How Forward Rate Agreements Work

FRAs usually involve swapping a fixed rate for a variable one. The party paying fixed is the borrower or long side, and the one paying variable is the lender or short side. You enter an FRA to lock in a rate if you think rates will rise, fixing your costs now. For instance, if the Federal Reserve is set to hike rates in a tightening cycle, companies fix borrowing before it gets expensive.

These agreements are flexible, with settlement dates customized to your needs. The cash difference between the FRA rate and the floating rate settles on the value or settlement date.

Formula and Calculation for a Forward Rate Agreement (FRA)

To calculate the FRA payment, use this formula: FRAP = ((R - FRA) × NP × P / Y) × (1 / (1 + R × (P / Y))). Here, FRAP is the payment, FRA is the fixed rate, R is the floating reference rate, NP is the notional principal, P is the number of days in the period, and Y is the days in the year per the day-count convention.

First, find the difference between the forward and floating rates. Multiply that by the notional and the days in the contract, then divide by 360. For the second part, divide the contract days by 360, multiply by the reference rate, add to 1, and divide 1 by that. Finally, multiply the two results.

Example of a Forward Rate Agreement

Consider Company A entering an FRA with Company B, where A receives a fixed rate of 4% on $5 million in six months, but the FRA is set 50 basis points below that. B receives the one-year term SOFR in three years on the same principal. SOFR is a key rate for dollar derivatives and loans, based on Treasury repo markets.

Settlement is cash at the forward period's start, discounted by the contract rate and period. Using FRA = 3.5%, R = 4%, NP = $5 million, P = 181 days, Y = 360: FRAP = (($0.04 - 0.035) × $5M × 181 / 360) × (1 / (1 + 0.04 × (181 / 360))) = $12,569.44 × 0.980285 = $12,321.64. If positive, the seller pays the buyer. Note, the $5 million isn't exchanged—just used for the differential.

Forward Rate Agreement (FRA) vs. Interest Rate Futures

FRAs differ from interest rate futures, though both derive from future rate expectations. The big distinction is customization: FRAs are OTC and tailored to your specs like notional, rate, and date. Futures are standardized on exchanges, less flexible but more liquid.

Counterparty risk is higher in FRAs since they're private; you must trust the other party won't default. Futures use exchange clearinghouses to guarantee trades, cutting that risk. Settlement for FRAs is cash at maturity based on rate differences, while futures mark to market daily. Futures also face more regulation for transparency.

Limitations of Forward Rate Agreements

FRAs have downsides: if rates move against you, you face losses on settlement. They're less regulated than futures, making it hard to close early, and counterparty default is a risk.

What Happens If You Sell a Forward Rate Agreement (FRA)?

As the seller or lender, you agree to a fixed rate later. If floating rates drop, you benefit from the locked higher rate.

Why Would You Buy a Forward Rate Agreement?

You buy an FRA to hedge against rising rates, locking in costs for future borrowing.

What Was LIBOR and Why Was It Abandoned?

LIBOR was a benchmark for interbank short-term loans. It was dropped due to manipulation scandals in the 2010s and the financial crisis showing its unreliability with fewer submissions.

The Bottom Line

In summary, an FRA sets a future interest rate via OTC contract, settling in cash on rate differences without exchanging notional. You can use it to hedge or profit from rate moves—borrowers fix costs, lenders lock rates if they expect falls.