Forward rate agreement
Encyclopedia
In finance, a forward rate agreement (FRA) is a forward contract
, an over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used along with the termination date and notional value. On this type of agreement, it is only the differential that is paid on the notional amount of the contract. It is paid on the effective date. The reference rate is fixed one or two days before the effective date, dependent on the market convention for the particular currency. FRAs are over-the counter derivatives. A FRA differs from a swap in that a payment is only made once at maturity.
Many banks and large corporations will use FRAs to hedge future interest rate exposure. The buyer hedges against the risk of rising interest rates, while the seller hedges against the risk of falling interest rates. Other parties that use Forward Rate Agreements are speculators purely looking to make bets on future directional changes in interest rates.
In other words, a forward rate agreement (FRA) is a tailor-made, over-the-counter financial futures contract on short-term deposits. A FRA transaction is a contract between two parties to exchange payments on a deposit, called the Notional amount, to be determined on the basis of a short-term interest rate,
referred to as the Reference rate, over a predetermined time period at a future date. FRA transactions are entered as a hedge against interest rate changes. The buyer of the contract locks in the interest rate in an effort to protect against an interest rate increase, while the seller protects against a possible interest rate decline. At maturity, no funds exchange hands; rather, the
difference between the contracted interest rate and the market rate is exchanged. The buyer of the contract is paid if the reference rate is above the contracted rate, and the buyer pays to the seller if the reference rate is below the contracted rate. A company that seeks to hedge against a possible increase in interest rates would purchase FRAs, whereas a company that seeks an interest hedge against a possible decline of the rates would sell FRAs.
How to interpret a quote for FRA?
[US$ 3x9 - 3.25/3.50%p.a ] - means deposit interest starting 3 months from now for 6 month is 3.25% and borrowing interest rate
starting 3 months from now for 6 month is 3.50% (see also bid–offer spread). Entering an "payer FRA" means paying the fixed rate (3.50 % p.a.) and receiving a floating 6-month rate, while entering a "receiver FRA" means paying the same floating rate and receiving a fixed rate (3.25 % p.a.).
Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
, an over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used along with the termination date and notional value. On this type of agreement, it is only the differential that is paid on the notional amount of the contract. It is paid on the effective date. The reference rate is fixed one or two days before the effective date, dependent on the market convention for the particular currency. FRAs are over-the counter derivatives. A FRA differs from a swap in that a payment is only made once at maturity.
Many banks and large corporations will use FRAs to hedge future interest rate exposure. The buyer hedges against the risk of rising interest rates, while the seller hedges against the risk of falling interest rates. Other parties that use Forward Rate Agreements are speculators purely looking to make bets on future directional changes in interest rates.
In other words, a forward rate agreement (FRA) is a tailor-made, over-the-counter financial futures contract on short-term deposits. A FRA transaction is a contract between two parties to exchange payments on a deposit, called the Notional amount, to be determined on the basis of a short-term interest rate,
referred to as the Reference rate, over a predetermined time period at a future date. FRA transactions are entered as a hedge against interest rate changes. The buyer of the contract locks in the interest rate in an effort to protect against an interest rate increase, while the seller protects against a possible interest rate decline. At maturity, no funds exchange hands; rather, the
difference between the contracted interest rate and the market rate is exchanged. The buyer of the contract is paid if the reference rate is above the contracted rate, and the buyer pays to the seller if the reference rate is below the contracted rate. A company that seeks to hedge against a possible increase in interest rates would purchase FRAs, whereas a company that seeks an interest hedge against a possible decline of the rates would sell FRAs.
Payoff formula
The netted payment made at the effective date is as follows- The Fixed Rate is the rate at which the contract is agreed.
- The Reference Rate is typically EuriborEuriborThe Euro Interbank Offered Rate is a daily reference rate based on the averaged interest rates at which Eurozone banks offer to lend unsecured funds to other banks in the euro wholesale money market .-Scope:...
or LIBOR. -
is the day count fraction, i.e. the portion of a year over which the rates are calculated, using the day count conventionDay count conventionIn finance, a day count convention determines how interest accrues over time for a variety of investments, including bonds, notes, loans, mortgages, medium-term notes, swaps, and forward rate agreements . This determines the amount transferred on interest payment dates, and also the calculation of...
used in the money markets in the underlying currency. For EUR and USD this is generally the number of days divided by 360, for GBP it is the number of days divided by 365 days. - The Fixed Rate and Reference Rate are rates that should accrue over a period starting on the effective date, and then paid at the end of the period (termination date). However, as the payment is already known at the beginning of the period, it is also paid at the beginning. This is why the discount factor is used in the denominator.
FRAs Notation
FRA Descriptive Notation and Interpretation| Notation | Effective Date from now | Termination Date from now | Underlying Rate |
|---|---|---|---|
| 1 x 4 | 1 month | 4 months | 4-1 = 3 months LIBOR |
| 1 x 7 | 1 month | 7 months | 7-1 = 6 months LIBOR |
| 3 x 6 | 3 months | 6 months | 6-3 = 3 months LIBOR |
| 3 x 9 | 3 months | 9 months | 9-3 = 6 months LIBOR |
| 6 x 12 | 6 months | 12 months | 12-6 = 6 months LIBOR |
| 12 x 18 | 12 months | 18 months | 18-12 = 6 months LIBOR |
How to interpret a quote for FRA?
[US$ 3x9 - 3.25/3.50%p.a ] - means deposit interest starting 3 months from now for 6 month is 3.25% and borrowing interest rate
starting 3 months from now for 6 month is 3.50% (see also bid–offer spread). Entering an "payer FRA" means paying the fixed rate (3.50 % p.a.) and receiving a floating 6-month rate, while entering a "receiver FRA" means paying the same floating rate and receiving a fixed rate (3.25 % p.a.).
See also
- Forward rateForward rateThe forward rate is the future yield on a bond. It is calculated using the yield curve. For example, the yield on a three-month Treasury bill six months from now is a forward rate.-Forward rate calculation:...
- Derivative (finance)Derivative (finance)A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
- List of finance topics
- Forward Rate Agreements on Wikinvest