A Forward Rate Agreement (FRA) is an interest rate derivative (IRD).
A forward rate agreement is an over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date.
The FRA determines the rates to be used along with the termination date and notional value. FRAs are cash settled with the payment based on the net difference between the interest rate and the reference rate in the contract.
There is no principal exchange – only the interest rates are tracked and used for cash settlement
By trading today at an interest rate that is effective at some point in the future, FRAs enable banks and corporates to hedge interest rate exposure. They may also be used to speculate on the level of future interest rates
The buyer may be using the FRA to hedge an actual exposure, that is an actual borrowing of money, or simply speculating on a rise in interest rates. The counterparty to the transaction, the seller of the FRA, is the notional lender of funds, and has fixed the rate for lending funds.
If there is a fall in interest rates the seller will gain, and if there is a rise in rates the seller will pay.
Again, the seller may have an actual loan of cash to hedge or be a speculator.
Usually FRA agreements are upto 12 months with cash settlement payouts every quarter.
As a basic example, Company A enters into an FRA with Company B in which Company A will receive a fixed rate of 3% for one year on a principal of USD 1 million.
In return, Company B will receive the one-year LIBOR rate on the principal amount.
The agreement will be settled in cash in a payment made at every quarter end.