Forward Rate Agreement (FRA)

What Is a Forward Rate Agreement (FRA)?

Forward rate agreements (FRA) are over-the-counter contracts between parties that decide the rate of interest to be paid on an agreed-upon date from here on out. In other words, a FRA is an agreement to exchange an interest rate commitment on a notional amount.

The FRA decides the rates to be utilized along with the termination date and notional value. FRAs are cash-settled. The payment depends on the net difference between the interest rate of the contract and the floating rate in the market — the reference rate. The notional amount isn't exchanged. It is a cash amount in view of the rate differentials and the notional value of the contract.

Formula and Calculation for a Forward Rate Agreement

$\begin &\text = \left ( \frac{ ( R - \text ) \times NP \times P } \right ) \times \left ( \frac{ 1 }{ 1 + R \times \left (\frac \right ) } \right ) \ &\textbf \ &\text = \text \ &\text = \text{Forward rate agreement rate, or fixed interest} \ &\text \ &R = \text{Reference, or floating interest rate used in} \ &\text \ &NP = \text{Notional principal, or amount of the loan that} \ &\text \ &P = \text{Period, or number of days in the contract period} \ &Y = \text \ &\text \ \end$

Ascertain the difference between the forward rate and the floating rate or reference rate.
Duplicate the rate differential by the notional amount of the contract and by the number of days in the contract. Partition the outcome by 360 (days).
In the second part of the formula, partition the number of days in the contract by 360 and duplicate the outcome by 1 + the reference rate. Then partition the value into 1.
Increase the outcome from the right half of the formula by the left half of the formula.

Forward rate agreements regularly include two parties trading a fixed interest rate for a variable one. The party paying the fixed rate is alluded to as the borrower, while the party paying the variable rate is alluded to as the lender. The forward rate agreement could have the maturity up to five years.

A borrower could go into a forward rate agreement determined to secure in an interest rate in the event that the borrower accepts rates could rise from now on. In other words, a borrower should fix their borrowing costs today by going into a FRA. The cash difference between the FRA and the reference rate or floating rate is settled on the value date or settlement date.

For instance, assuming the Federal Reserve Bank is currently climbing U.S. interest rates, called a monetary tightening cycle, corporations would probably need to fix their borrowing costs before rates rise too decisively. Additionally, FRAs are truly flexible, and the settlement dates can be tailored to the necessities of those engaged with the transaction.

Forward Rate Agreements (FRA) versus Forward Contracts (FWD)

A forward rate agreement is not quite the same as a forward contract. A currency forward is a binding contract in the foreign exchange market that secures in the exchange rate for the purchase or sale of a currency on a future date. A currency forward is a hedging tool that includes no upfront payment. The other major benefit of a currency forward is that it tends to be tailored to a particular amount and delivery period, in contrast to normalized currency futures.

The FWD can bring about the currency exchange being settled, which would incorporate a wire transfer or a settling of the funds into an account. There are times while an offsetting contract is placed, which would be at the common exchange rate. Nonetheless, offsetting the forward contract brings about settling the net difference between the two exchange rates of the contracts. A FRA brings about 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, given that the option is mutually acceptable and has been determined beforehand in the contract.

Limitations of Forward Rate Agreements

There is a risk to the borrower in the event that they needed to unwind the FRA and the rate in the market had moved adversely so the borrower would write off the cash settlement. FRAs are extremely liquid and can be loosened up in the market, yet there will be a cash difference settled between the FRA rate and the overall rate in the market.

Illustration of a Forward Rate Agreement

Company A goes into a FRA with Company B where Company A will receive a fixed (reference) rate of 4% on a principal amount of $5 million of every one half a year and the FRA rate will be set at 50 basis points not exactly that rate. In return, Company B will receive the one-year [LIBOR], not entirely settled in three years' time, on the principal amount. The agreement will be settled in cash in a payment made toward the beginning of the forward period, discounted by an amount calculated utilizing the contract rate and the contract period.

The formula for the FRA payment considers five 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 in light of the right day-count convention for the contract

Accept the accompanying data, and connecting it to the formula above:

FRA = 3.5%
R = 4%
NP = $5 million
P = 181 days
Y = 360 days

The FRA payment (FRAP) is consequently calculated as:
$\begin \text &= \left (\frac{ (0.04 - 0.035) \times $5\ \text \times 181 }{ 360 } \right ) \ &\quad \times \left ( \frac{ 1 }{ 1 + 0.04 \times \left ( \frac{ 181 }{ 360 } \right ) } \right ) \ &= $12,569.44 \times 0.980285 \ &= $12,321.64 \ \end$
Assuming the payment amount is positive, the FRA seller pays this amount to the buyer. Otherwise, the buyer pays the seller. Keep in mind, the day-count convention is commonly 360 days in a year. Note additionally that the notional amount of $5 million isn't exchanged. All things being equal, the two companies associated with this transaction are utilizing that figure to work out the interest rate differential.

Features

The notional amount isn't exchanged, yet rather a cash amount in view of the rate differentials and the notional value of the contract.
A borrower should fix their borrowing costs today by going into a FRA.
Forward rate agreements (FRA) are over-the-counter contracts between parties that decide the rate of interest to be paid on an agreed-upon date from here on out.