Forward Rate Agreement (FRA) is a financial agreement that enables two parties to lock in an interest rate for a future date. It is a derivative contract between two parties where the seller agrees to pay the buyer the difference between a predetermined interest rate and the prevailing market rate at a specified future date.
FRAs are commonly used by banks, financial institutions, and other companies that have interest rate risk exposure. They use FRAs to manage their interest rate risk by hedging their future cash flows.
For example, let`s assume that a bank expects to receive a payment of $1 million in six months. The bank is concerned about the possibility of interest rates increasing over the next six months. To hedge this risk, the bank can enter into a FRA with another party to fix the interest rate on the payment.
Suppose the current six-month LIBOR rate is 2%, and the bank expects the rate to increase to 3% in six months. To hedge its interest rate risk, the bank can enter into a FRA with another party where it agrees to receive 2.5% on its payment in six months. If the six-month LIBOR rate increases to 3%, the bank will receive a payment of $12,500 from the other party, which is the difference between the fixed rate of 2.5% and the prevailing market rate of 3%.
FRAs are generally traded over-the-counter (OTC) and are not standardized. This means that the terms and conditions of each FRA can differ based on the agreement between the two parties.
In conclusion, a Forward Rate Agreement is a financial contract used to manage interest rate risk. It enables parties to lock in an interest rate for a future date, providing certainty on future cash flows. Banks, financial institutions, and companies regularly use FRAs to manage their interest rate exposure.