Forward Rate Agreement (FRA)

A forward rate agreement (FRA) is a financial derivative contract in which two parties agree to exchange interest rates on a notional amount of money at a future date. The contract is settled at the future date based on the difference between the agreed-upon forward rate and the market rate at that time.

FRAs are used to manage interest rate risk. For example, a company that expects to borrow money in the future can use an FRA to lock in a fixed interest rate. A company that expects to invest money in the future can use an FRA to protect against a decline in interest rates.

FRAs are traded over-the-counter (OTC) between banks and other financial institutions. The notional amount of an FRA is typically $1 million or more. The contract period can be any length of time, but most FRAs are for one year or less.

The most common type of FRA is a plain vanilla FRA. In a plain vanilla FRA, the two parties agree to exchange interest rates on a notional amount of money at a future date. The forward rate is the interest rate that is agreed upon at the time the contract is entered into. The market rate is the interest rate that is prevailing at the future date when the contract is settled.

The difference between the forward rate and the market rate is called the swap spread. The swap spread is the profit or loss that the party that entered into the FRA will make or lose.

FRAs are a versatile tool that can be used to manage interest rate risk. However, it is important to understand the risks associated with FRAs before entering into a contract.