Table of Contents
What is FRA?
When two parties decide upon a future rate for an interest payment, it is known as FRA. It is an interest rate derivative, where two parties make an over-the-counter agreement for the interest payment in the future and at an agreed rate.
Some people may confuse FRA with future contracts, as both are derivatives and are generally used where transactions are in foreign exchange. But the significant difference between the two is that the former is aimed at cash settlement of interest rate differentials, and the latter is aimed at settlement of the net difference between the two exchange rates of the contracts.Â
What Does FRA Stand for?
FRA stands for Forward Rate Agreement.Â
In the Forward Rate Agreement, two parties decide the interest to be paid, along with the ending date of the contracts and the principal value (that is notional). An important point to note here is that the principal value is a hypothetical value that is not exchanged (borrowed or lent). It is the difference between the two exchange rates that both buyer and seller agree upon at the beginning of the contract.
How does a Forward Rate Agreement work?
FRA is an interest rate agreement that is settled at a future date. The interest rate, borrowing or lending, is fixed by the buyer and the seller of the contract, respectively. The FRA payment is determined by the difference between the interest rate specified in the contract and the market rate of interest.
The two parties involved in an FRA are the buyer and the seller. The fixed interest rate of the contract is determined by an assumed principal amount, which is not a part of the transaction, but a notional value to calculate the interest.Â
Neither parties of the contract are in profit or loss at the beginning of the FRA. When interest is paid at a future date, the difference between the market interest rate (also known as the floating rate or reference rate) and the interest rate fixed in the contract is calculated.Â
If the reference rate is higher than the interest rate fixed in the contract, it is profitable for the buyer. However, if the reference rate is less than the contract rate, the seller will make a profit.Â
How is FRA Calculated?
Amount = {[(RR-FR) PxT] Y } { 1 [ 1 + RR (T/Y)]}Â
To calculate the FRA, certain values are required, likeÂ
FR= rate of interest fixed on the FRA contract
RR= Reference rate or floating market rate
P= the assumed principle or notional value for the calculation of the interest
T= No. of days for which the contract is created
Y= Total days in a year, which is taken as 360 days
Putting the above values in the formula, the amount paid towards the Forward Rate Agreement rate can be calculated. If the FRA amount is negative, the buyer makes the payment to the seller. If it is positive, the seller has to pay the buyer.Â
What is FRA in Banking?
Â
What is the Settlement Date in FRA?
The date decided upon by the buyer and seller of the FRA contract, on which the agreement is settled, or the interest is paid, is known as the settlement date.
An FRA contract is a timed contract that comes with a validity period. The settlement date is when the difference between the FRA fixed interest rate and the floating rate is calculated, and hence the transaction takes place.Â
How Do You Read FRA Quotes?
FRAs are generally presented in terms of quotes. These quotes include the period before the contract becomes effective and the time left till the termination of the contract. It helps in determining the start date and termination date of the contract.
For example, a 2×5 FRA quote would mean that the FRA contract is effective for three months (5-2) or 90 days, starting from 60 days or two months from when the contract is entered.Â
What are the Benefits of FRAs?
One of the significant benefits of FRA is that the buyer of FRA, who is planning to borrow funds at a future date, can lock in the interest before making the transaction. It will help the buyer avoid interest rate exposure that may adversely affect their future interest payment.
As the market is the most unpredictable place, it can considerably affect future transactions. If the period is more extended, then the risk becomes even higher. To avoid such market risks, people enter into the Forward Rate Agreement. It helps in getting rid of such risks, but not entirely.Â
Banks or financial institutes generally undertake such agreements. However, some traders also use it as a trade earning technique. Also, such contracts do not usually affect the financial ratios as they are off-balance sheet transactions. Â
What are the Waiting Period and Contract Period in FRA?
The Waiting Period and the Contract Period are the two essential parts of an FRA contract. These two describe the life cycle of the FRA contract.
The waiting period, in a Forward Rate Agreement, refers to the number of days or months remaining for the commencement of the agreement, while the contract period refers to the number of days or months for which the contract will remain effective.
For example, an FRA becomes effective after two months from when the two parties entered the contract. It will remain effective for four months from the date of commencement. Therefore, the waiting period here is two months or 60 days and the contract period is four months or 120 days. It can also be expressed as 2×6.
What Does 3×6 FRA Mean?
3×6 is an FRA quote that indicates the initiation and ending period of an FRA contract. Here, 3 represents the time from which the agreement becomes effective, three months or 90 days in this example. Six refers to the termination period of the contract, which is six months or 180 days, from the date both parties signed the contract.
The above FRA quote shows that the agreement will remain effective for 3(6-3) months or 90 days.Â
Â
Is Forward Rate Agreement a Derivative?
Yes, the Forward Rate Agreement is a derivative. To be precise, it is an interest rate derivative or IRD.Â
Derivatives are used to hedge or protect future transactions from market risks. The FRA is one such derivative that is commonly used to neutralize future market fluctuations that may affect interest rate payments.Â
Who Uses Forward Rate Agreements?
Forward Rate Agreements are generally used by people who have future plans to acquire a loan from a bank or a financial institution. Traders also use it to earn from interest differentials.
It is imperative to know that FRA does not always work in favor of the buyer. It will either be profitable for the seller or the buyer. One would have to incur the loss for the other to earn profits. Therefore, it is vital to understand the market situation before locking in the interest rate in the Forward Rate Agreement.Â
