Forward rate agreement

FRA
A forward rate agreement (FRA) is an agreement that a certain rate will apply to a certain principal during a certain future time period

FRA - History
FRAs originated in 1981 amongst large London Eurodollar banks that used these forward agreements to hedge their interest rate exposure. Today, FRAs are offered by banks and financial institutions in major financial centers and are often written for the bank s corporate customers. They are customized contracts (OTC)designed to meet the needs of the corporation or financial institution.

FRA
jA forward rate agreement (FRA) is a forward contract to borrow/lend money at a certain rate at some future date. j In practice, these contracts settle in cash, but no actual loan is made at the settlement date. jThe long position in an FRA is the party that would borrow the money. j If the floating rate at contract expiration is above the rate specified in the forward agreement, the long will receive a compensation. jIf the reference rate is below the contract rate, the short will receive a cash payment from the long.

FRA rate
For example, a 39 FRA is a 3-month forward on a 6-month loan the loan commences in 3 months and matures in 9. The interest rate on the loan called the FRA rate is set when the contract is first entered into.

Banks and FRA

The banks that write FRAs often takes a position in the futures market to hedge their position or a long and short position in spot money market securities to lock in a forward rate.

Features of FRA
Principal is not exchanged because FRA is not a financing tool but interest rate risk management tool. Interest rate is not borrowed or lent, but paid or received. FRA is tool to pit known interest rate (i.e. fixed rate) against unknown interest rate (i.e. floating rate).

Netting
The two interest amounts are not settled separately but netted into a single amount. The purpose of netting is to mitigate the settlement risk. Consider the situation in which Party A has to pay 100 and Party B has to pay 90. If there is no netting, the settlement risk to Party A is 90 and to Party B, 100. If both amounts are netted into single amount of 10, which is payable by Party A to party B, then settlement risk is eliminated for Party A and reduced to 10 for Party B.

Applications of FRA
Applicationsof FRA Like all derivatives, FRA is used for speculation and hedging. For a speculator, if he expects the interest rate to rise in future, he would FRA today; and if he expects the rates to fall in future, he would sell FRA today. For hedger, FRA locks the interest rate on future deposit or loan. If he has a borrowing requirement in future, he should buy FRA today; and he has cash surplus in future, he should sell FRA today. Note that for hedger, the fixed rate of FRA is not the final rate for the underlying interest exposure. FRA manages the interest rate risk of market benchmark. In contrast, the cash market offers to loan to the borrower at the market rate plus the credit risk premium applicable to the borrower, which is specific to the borrower.