Definition of Forward Rate Agreement
Forward rate agreement is the type of OTC contract which is cash-settled and is contracted between the two parties where the buyer borrows, and the seller lends a notional sum which is having a fixed interest rate and the period of time is also specified that starts at an agreed date in future, or in simple words, it is a forward starting loan where there is no exchange of principal.
There is no exchange of principal in the forward rate agreement, but it is the type of forward starting loan. The interest payment is calculated by simply using the notional amount. The interest rates that will be effective at some point in the future, the forward rate agreement allows the market participants to trade today and also allow them to hedge their interest rate exposure on future agreements.
There will be a protection to both buyer and the seller. The buyer locks in the borrowing rate and gets protected against the rise in an interest rate, and the seller gets protected against a fall in interest rate because he obtains a fixed lending rate.
The formula for Forward Rate Agreement
The formula for forward rate agreement (fra) is as follows:
FRAP= [(R – FRA) * NP * P)/Y] * [1/1 + R *(P/Y)]
- FRAP= Forward Rate Payment
- FRA= Forward Rate Agreement
- R= Floating Interest rate, which is used in the contract
- NP= Notional principal amount on which interest is calculated
- Y= Number of days in the year-based contract used in day count generally is 365 days or 360 days depending on case to case.
- P= Period of the contract calculated as the number of days.
Examples of Forward Rate Agreement
Let’s consider Company ABC Ltd, which is planning to borrow the $5,000,000 in 6 month time period. The interest rate for the borrowing of the required funds is 6 months LIBOR plus 40 basis points. Let’s assume that the 6 month LIBOR is currently at 0.92, but there is the possibility that it will rise further by 1.5% in the upcoming months.
The company chooses to buy the 6*12 FRA for six months starting from now. He receives the interest rate quotation at the rate of 0.97% from his bank for the sum of $5,000,000 on May 15th. Now, suppose on the fixing date, the 6 month LIBOR rate is 1.28, which is also the settlement rate applicable for the company’s FRA. Suppose the number of days from the fixing date= 182 days. In this case, the company will be considered as the seller and will receive the settlement amount, which will be calculated as:
- Interest Differential = (1.28 – 0.97) * (182/360) * 5,000,000
- Interest Differential = $783,611.11
On the settlement date, the company will receive,
- = 783,611.11/ (1+1.28)*(182/360)
- = $475,749.106
Forward Rate Agreement Diagram
The above diagram represents the forward rate agreement. It can be seen from the above diagram that an FRA life is composed of two periods, i.e. waiting period (d1 to d3) and contract period (d3 to d4). The date d0 is the date of trading when FRA is negotiated among the two counterparties. The date d1 is the spot date which is generally two working days after the trade date. The date d2 is the fixing date on which the reference rate is being determined. The date d3 is the settlement date which is generally two working days after the fixing date, and it is the date on which the notional loan period begins and which settlement amount is paid. The date d4 is the maturity date on which the notional loan expires.
Applications of Forward Rate Agreement
More frequently, FRAs are used by the banks for the applications like hedging interest rate exposures that arise from the mismatches in money market books. Also, FRAs are used for speculative activities.
Valuation of Forward Rate Agreement
The valuation of the forward rate agreement is done based on the sale perspective and the cash difference which arise as a result of an exchange of FRA between the two parties.
Uses of Forward Rate Agreement
The following are the uses of forward rate agreement:
Many banks and many large-sized corporations use it to hedge exchange rate exposure and future interest. Both buyers and the seller’s hedges against the risks like the seller hedges against the risk of falling interest rate while the buyer hedges against the risk of the rising interest rate. Other than buyers and the sellers, there are other parties who act like the speculators and use the forward rate agreement who make the bets based on future directional changes in the interest rate.
It is a customized contract based on the requirement of the parties as it offers various options include over counter financial options on short term deposits.
- It protects the buyer against the rise in interest rate as the buyer locks in the borrowing rate.
- It protects the seller against a fall in interest rate because he obtains a fixed lending rate.
- It provides guaranteed interest rates.
- FRAs are fully customizable, and thus they are flexible.
- There is no requirement of the principal amount
- There is no possibility of getting the benefits from favourable fluctuation in the interest rate between the date of determination and the date of settlement.
- Hedging remains effective even if underlying does not exist.
- There is an exchange rate risk when the unhedged agreement is in foreign currency.
Thus forward rate agreement (FRA) is a forward contract entered with the motive of setting the interest rate for a future transaction. In this, there is an over-the-counter (OTC) agreement between the two parties with which a fixed rate of interest is guaranteed to the borrower and lender for a specified period and specified amount. With the forward rate agreement, there will be protection to both the parties of the agreement, i.e. the buyer and the seller.
This is a guide to Forward Rate Agreement. Here we also discuss the definition and example of forward rate agreement along with advantages and disadvantages. You may also have a look at the following articles to learn more –