Forward Rate Agreement: what it is and how it works financially

Does the term Forward Rate Agreement sound familiar to you? Here’s a clue: it’s a type of contract. If you work in a company’s financial area, you might already know this concept. If not, you’re in luck, because in this post we’ll explain it to you.

Forward Rate Agreement (FRA) contracts are agreements between two parties that determine the interest rate to be paid on a specific future date. It’s an over-the-counter (OTC) contract, meaning it is traded directly between the parties rather than on a centralized exchange. 

Characteristics of Forward Rate Agreement Contracts

Understanding the structure of Forward Rate Agreement contracts can be complex. That’s why we’re sharing some of their main features and components to help shed some light on the subject. Let’s dive in! 

• Interest rate agreement: the FRA establishes an agreement between two parties to exchange cash flows in the future based on predetermined interest rates. 
• Start and maturity dates: the contract specifies both the start date and the maturity date of the agreement. 
• Principal and interest rate: the principal on which the cash flows will be calculated and the interest rate applied to those calculations are specified. 
• Reference rate and agreed rate: the contract includes a reference rate (e.g., LIBOR) and an agreed rate. The agreed rate is the rate at which the parties commit to exchange cash flows at the contract’s maturity date. 
• Net payments: on the maturity date, one party will make a net payment to the other, depending on whether the reference rate is higher or lower than the agreed rate. 
• Flexibility: FRA contracts can be flexible in terms of duration, notional amount, and settlement frequency. 
• Cash settlement: FRAs are settled in cash — there is no physical exchange of principal, only a net cash adjustment based on the difference between the reference rate and the agreed rate. 

Regarding their use, FRA contracts are mainly used by financial institutions and companies to hedge against the risk of changes in interest rates. For example, a company expecting to borrow money in the future can use an FRA to protect itself from unexpected increases in interest rates. 

Settlement of Forward Rate Agreement Contracts

Settlement, in the financial context, refers to the process by which financial transactions are completed. In the case of FRA contracts, the settlement takes place on the contract’s maturity date and may occur in different ways depending on whether the reference rate at maturity is higher or lower than the rate agreed upon in the contract.

Here are the two main settlement scenarios: 

• Reference rate higher than the agreed rate (higher variable rate): in this case, the party that purchased protection (the FRA buyer) receives a net payment from the seller.
• Reference rate lower than the agreed rate (lower variable rate): in this case, the party that sold protection (the FRA seller) receives a net payment from the buyer.

Positions in an FRA Agreement: Buyer and Seller

Earlier, we mentioned two key positions in an FRA agreement — the buyer and the seller. Understanding each role will help you gain a clearer picture of how the contract works and how settlement is determined. 

Specifically, the buyer is the one who purchases protection against the risk of rising interest rates. They commit to paying the difference between the market reference rate at maturity and the rate agreed upon in the contract if the reference rate is higher than the agreed rate.

On the other hand, the seller offers protection against the risk of falling interest rates. In contrast to the previous case, the seller agrees to pay the difference between the agreed rate and the market reference rate if the reference rate is lower than the agreed rate.

Advantages of Forward Rate Agreement Contracts

Finally, it’s important to understand the advantages of these contracts for institutions seeking to manage and mitigate their exposure to interest rate risk. Take note! 

• Hedging: FRAs provide an effective way to hedge against adverse fluctuations in interest rates. The parties can lock in a future interest rate through an FRA, protecting themselves against unfavorable movements in market rates. 
• Flexibility: they are flexible in terms of duration, amount, and start date. This allows the parties to adapt contracts to their specific needs and align them with their risk management strategies. 
• Preserving borrowing capacity: by fixing future interest rates through FRAs, parties can protect their borrowing capacity from potential interest rate increases. 
• Interest rate risk management: they allow financial institutions and companies to proactively manage their exposure to interest rate risk. 
• Reduced financial volatility: the parties can reduce volatility in their financial results and improve the stability of their business operations.

If you find this topic interesting, you can read more about how financial markets work or explore strategies to create a company’s financial plan. We invite you to subscribe to Educa.Pro and start enjoying a wide range of specialized training with no limits today!