Forward Rate Agreement Meaning & Definition

Forward Rate Agreement

What is a Forward Rate Agreement

A forward rate agreement (FRA) is cash-settled forward contracts based on the difference between a fixed rate and a floating reference rate in force for the period covered in the FRA. If you buy a FRA you are agreeing to pay a fixed rate; if you sell a FRA you are agreeing to receive a fixed rate.

SecuritiesCE Explains Forward Rate Agreement

The terminology used might appear as a ‘3 x 6 FRAÕ meaning an agreement to pay/receive a fixed rate of interest starting in 3 months’ time and ending in 6 months’ time (therefore for a 3 month period).

• A company is going to receive $1m from the sale of an asset in 1 month’s time and will not need the cash until 6 months later. It decides it will deposit the money in a bank account to earn interest for 6 months when it receives the cash. The CFO is concerned that interest rates might fall and wants to lock in to a rate now.
• What should he do? If he buys a FRA he will make money out of rising rates. If he sells a FRA he will make money out of falling rates. To protect the interest rate on a deposit he therefore wants to sell a FRA, generating profits if rates fall. This will offset the lower rate on the deposit. Here he would want to sell a 1 x 7 FRA.
• A bank quotes a 4.5% 1 x 7 FRA; the treasurer agrees to sell and in 1 month’s time LIBOR has risen to 5%.
• Did the CFO generate a profit or loss by entering the FRA? He sold at 4.5%; but the interest rate is now 5% so the contract has made a loss. But he would now get a high rate on the deposit.
• But how much of a loss was made on the FRA?

Step 1
Calculate the difference in interest rates. In this example the company receives 4.5% and pays 5.0%. The annual difference is a 0.5% loss.
 
Step 2
Pro-rate the difference for the length of the contract -0.005 x 180/360 = -0.0025
 
Step 3
Apply the pro-rated difference in interest rates to the notional value of the contract. -0.0025 x $1,000,000 = -$2,500
 
Step 4
Discount the cash flow back to the expiration date. The payoff occurs at the expiration date therefore need to be discounted at LIBOR for six months. -$2,500 / 1.025 = $2,439

This term has been provided by Fitch Learning
Fitch Learning is the premier training provider for the CFA, CQF and advanced professional development courses. To learn more about how Fitch Learning can help you advance your career click here