Forward rate contracts (FRAs) are over-the-counter contracts between parties that determine the interest rate to be paid at an agreed time in the future. A FRA is an agreement to exchange an interest obligation for a nominal amount. FRA can be based on different periods and are quoted in months until the settlement date and in months until the end of the interest period. In our example, the settlement date is after 60 days (2 months), then there is an interest period of 90 days (3 months). The contract is concluded after a total of 2+3 = 5 months. This FRA is called 2×5 FRA. The forward rate agreement, commonly known as FRA, refers to bespoke financial contracts that are traded over-the-counter (OTC) and allow counterparties, which are mainly large banks, to predefine interest rates on contracts that will start at a future date. The valuation of the forward rate agreement will be based on the prospect of sale and the cash difference resulting from an exchange of FRA between the two parties. Forward rate contracts (FRUs) are similar to futures contracts in which a party agrees to borrow or lend a certain amount of money at a fixed interest rate at a predetermined future date. There is a risk for the borrower if he were to liquidate the FRA and the interest rate on the market had moved negatively, so that the borrower would suffer a loss of the cash settlement. FRA are very liquid and can be settled in the market, but there will be a cash flow difference between the FRA rate and the prevailing market rate. FRA contracts are usually settled in cash, which means that the money is not actually lent or borrowed.
Instead, the forward rate set in the FRA is compared to the current LIBOR rate. If the current LIBOR is higher than the FRA interest rate, the long one is actually able to borrow at a lower rate than the market. The long therefore receives a payment based on the difference between the two rates. However, if the current LIBOR was lower than the FRA rate, Long will make a payment in the shorts. Ultimately, the payment compensates for any change in interest rate since the date of the contract. The forward rate agreement is the type of over-the-counter contract that is settled in cash and is contractually agreed between the two parties when the buyer takes out loans and the seller lends a notional sum at a fixed interest rate, and the period that begins at an agreed time in the future is also indicated, or in simple terms, it is a term start-up loan where there is no capital exchange. Let`s look at ABC Ltd, which plans to borrow the $5,000,000 over a 6-month period. The interest rate to borrow the required funds is 6 months of LIBOR plus 40 basis points. Let`s assume that 6-month LIBOR is currently at 0.92, but it is possible that it will continue to rise by 1.5% in the coming months. Rate futures (FRA) contracts are linked to short-term interest rate futures (STIR futures). Since STIR futures are charged on the same index as a subset of FRA, the FRA IMM, their price is interdependent.
The nature of each product has a distinctive gamma profile (convexity), which leads to rational price adjustments, without arbitration. This adjustment is called a forward convexity adjustment (FCA) and is usually expressed in basis points. [1] The example above shows how FRA are used to guarantee an interest rate or the cost of debt. FRA can also be used to guarantee the price of a short-term security to be bought or sold in the near future. Consider a FRA 3×6 on a fictitious capital amount of $1 million. The FRA rate is 6%. The payment date fra is 3 months (90 days) and billing is based on a LIBOR of 90 days. Most often, FRA are used by banks for applications such as hedging interest rate risks resulting from asymmetries in money market books. FRA are also used for speculative activities.
For example, if the Federal Reserve is about to raise U.S. interest rates, which is called a monetary tightening cycle, companies will likely want to cut borrowing costs before interest rates rise too drastically. In addition, FRA are very flexible and billing dates can be adjusted to the needs of the people involved in the transaction. .