Forward Rate Agreement (FRA)

What is an FRA?

A forward rate agreement (FRA) is an over-the-counter (OTC) derivative contract that fixes an interest rate to be paid on a notional amount for a specified future period. One party agrees to pay a fixed rate (the long side/borrower) and the other pays a floating rate tied to an interest-rate index (the short side/lender). No principal is exchanged; the contract is settled in cash for the interest-rate difference on the settlement date.

FRAs are customizable in tenor, notional, and settlement terms and are commonly used to hedge or speculate on future interest-rate movements.

Key points

• OTC contract between two parties; terms are negotiable.
• Notional principal is not exchanged—only the discounted cash difference is paid.
• Used to lock in borrowing costs or to hedge exposure to rising/falling rates.
• Provides a direct market view of expected short-term interest rates.
• Exposes parties to counterparty (credit) risk.

How FRAs work

• Parties agree today on a fixed rate for a future interest period (e.g., 90 days starting in 6 months).
• At the start of the forward period, the contract is settled in cash. The settlement equals the present value of the difference between the floating reference rate realized for that period and the agreed fixed FRA rate, multiplied by the notional and day-count fraction.
• If the floating rate exceeds the fixed FRA rate, the fixed-rate payer (buyer of the FRA) receives the net payment; if lower, the fixed-rate payer pays.

FRA payment formula

The standard cash settlement formula is:

FRAP = ((R − FRA) × NP × P / Y) × (1 / (1 + R × (P / Y)))

where:
* FRAP = FRA payment (present-value of the rate difference)
* FRA = agreed fixed rate (decimal)
* R = realized reference floating rate (decimal)
* NP = notional principal
* P = number of days in the contract period (or accrual period)
* Y = days in year per day-count convention (commonly 360)

Calculation steps:
1. Compute the un-discounted interest difference: (R − FRA) × NP × (P / Y).
2. Discount that amount to the settlement date by dividing by (1 + R × (P / Y)).

Example

Assume:
* FRA = 3.5% (0.035)
R = 4.0% (0.04)
NP = $5,000,000
P = 181 days
Y = 360 days

Un-discounted difference = (0.04 − 0.035) × $5,000,000 × (181 / 360) = $12,569.44
Discount factor = 1 / (1 + 0.04 × (181 / 360)) ≈ 0.980285
FRAP ≈ $12,569.44 × 0.980285 ≈ $12,321.64

If FRAP is positive, the FRA seller pays the buyer; if negative, the buyer pays the seller.

FRA vs. interest rate futures

Customization
– FRA: customizable OTC agreement (any notional, dates, fixed rate).
– Futures: standardized exchange-traded contracts (fixed sizes and expiries).

Counterparty risk
– FRA: bilateral credit risk; depends on counterparty creditworthiness.
– Futures: cleared through an exchange, which substantially reduces counterparty risk.

Settlement and liquidity
– FRA: cash-settled at contract start of the forward period; liquidity can be limited for bespoke terms.
– Futures: marked to market daily; generally more liquid and transparent.

Limitations and risks

• Counterparty (credit) risk due to OTC nature.
• Potential difficulty closing or transferring an FRA before maturity.
• Market risk: unfavorable rate moves lead to cash settlement losses.
• Lower regulatory oversight compared with exchange-traded products.
• Model and day-count conventions must be applied correctly; small errors affect settlement amounts.

Common questions

Q: What happens if you sell an FRA?
A: As the seller (fixed-rate receiver), you benefit if the floating market rate falls below the fixed rate because you receive the net settlement.

Q: Why buy an FRA?
A: To hedge expected increases in borrowing costs by locking in a future borrowing rate today.

Q: What replaced LIBOR in many contracts?
A: Benchmarks such as the Secured Overnight Financing Rate (SOFR) in USD and other overnight alternative reference rates have replaced LIBOR because of past manipulation and shrinking contributor panels.

Conclusion

FRAs are flexible OTC tools for managing short-term interest-rate exposure by fixing borrowing or lending rates for a future period. They offer tailored hedging but carry counterparty and liquidity considerations that users must manage. When used appropriately, FRAs provide a cost-effective way to lock in future financing costs or to take view on future rate movements.

Selected sources

• John C. Hull, Options, Futures, and Other Derivatives
• Pooya Farahvash, Asset-Liability and Liquidity Management
• YieldCurve.com — Learning Curve: Forward Rate Agreements