A forward rate agreement (FRA) is a financial instrument that helps investors to hedge against interest rate risk. It is a contract between two parties, where one party agrees to pay the other party a predetermined interest rate on an agreed-upon notional amount at a future date. The FRA is settled in cash, and no physical delivery of any underlying asset takes place.
Let`s take an example of how a Forward Rate Agreement works in practical terms. Suppose a company wants to borrow $10 million in six months to finance its new project. However, the company`s management is concerned that interest rates may increase in the next six months, which would increase the cost of borrowing. To hedge against this interest rate risk, the company can enter into an FRA with a bank.
The FRA is an over-the-counter (OTC) contract, which means that it is a private agreement between the two parties and not traded on any exchange. In this contract, the company agrees to pay the bank a fixed interest rate of 3.5% per annum on the notional amount of $10 million for a period of six months starting from the settlement date.
Suppose the prevailing market interest rate for a six-month loan is 4%, and the settlement date is six months from now. At the settlement date, the company will calculate the difference between the fixed rate of 3.5% and the prevailing market interest rate of 4% on the notional amount of $10 million.
If the market interest rate is higher than the fixed rate, the bank will pay the company the difference between the fixed rate and the prevailing market rate. If the market interest rate is lower than the fixed rate, the company will pay the bank the difference between the two rates.
For example, if the market interest rate is 4.5%, the bank will pay the company 0.5% on the notional amount of $10 million, which is $50,000. On the other hand, if the market interest rate is 3.5%, the company will pay the bank nothing as there is no difference between the two rates.
In conclusion, a Forward Rate Agreement is a useful financial instrument for hedging against interest rate risk. It allows investors to lock in a fixed interest rate for a future date and provide certainty in the cost of borrowing. However, it is essential to understand both the risks and benefits of FRA before entering into any contract.