Forward Rate Agreement

A Forward Rate Agreement (FRA) is a financial instrument that allows two parties to agree on an interest rate to be applied to a notional amount of funds on a future date. The FRA is essentially an agreement to hedge against potential interest rate fluctuations.

In an FRA, one party agrees to pay the other a fixed rate of interest on a notional amount of funds for a specific period of time, while the other party agrees to pay a floating rate of interest on the same notional amount of funds. The fixed rate of interest is agreed upon at the outset of the contract and is based on the prevailing interest rates in the market.

FRAs are used by businesses and investors to manage interest rate risk associated with future cash flows. For example, a company that plans to borrow money in six months may enter into an FRA to lock in a favorable interest rate for that future borrowing.

FRAs are typically settled in cash, with the party that agreed to pay the fixed rate of interest receiving a payment from the party that agreed to pay the floating rate of interest. The amount of the payment is based on the difference between the agreed-upon fixed rate and the actual floating rate that applies to the notional amount of funds at the time of settlement.

Overall, FRAs are a useful financial instrument for managing interest rate risk associated with future cash flows. By using an FRA to lock in a favorable interest rate, businesses and investors can protect themselves against potential losses due to changes in interest rates.