Forward rate agreement (FRA) is an over-the-counter contract in which one party pays a fixed interest rate, and receives a floating interest rate equal to a reference rate (the underlying rate). The payments are calculated over a notional amount over a certain period, and netted, i.e. only the differential is paid. It is paid on the effective date.
Many banks and large corporations use FRAs to hedge future interest rate exposure. The buyer hedges against the risk of rising interest rates, while the seller hedges against the risk of falling interest rates. Other parties that use Forward Rate Agreements are speculators purely looking to make bets on future directional changes in interest rates.
The payer of the fixed interest rate is also known as the borrower or the buyer, whilst the receiver of the fixed interest rate is the lender or the seller.
What happens if the interest rate outlook changes after I have entered into the FRA?
If your view of interest rates changes at any time after you have entered into the FRA, you have two choices. You can terminate the FRA, in which case the Bank will calculate any residual value and either the Bank will pay you this amount or you will pay the amount to the Bank. The residual value will depend on current interest rates at the time of termination. Alternatively, you can enter into an equal but opposite FRA which cancels the original transaction, leaving a residual value to be paid on the commencement date of the new FRA.
Risks
By entering into a FRA you have expressed your view on interest rates. Should interest rate movements be different to your expectations the FRA may have the opposite effect to what you were trying to achieve with the transaction. Other risks are the country risk and credit risk.
