Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options, Second Edition

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Forward Rate Agreements

INTRODUCTION

A forward rate agreement (FRA) is a bilateral contract fixing the rate of interest applying to a notional principal amount of money for an agreed future time period. One party is said to be the FRA buyer and the other the seller. However the notional principal never changes hands. It is simply used to calculate the settlement sum.

• FRA Buyer. The buyer is paid a settlement sum by the seller if the reference or benchmark interest rate for the contract period turns out to be above that agreed in the contract.

• FRA Seller. The seller is paid a settlement sum by the buyer if the benchmark interest rate turns out to be below the contractual rate.

An FRA is a derivative instrument because its value is derived from spot or cash market interest rates, that is, the interest rates on deposits and loans starting now rather than in the future. This is illustrated in this chapter.

Users of FRAs

The natural buyers of FRAs are corporate borrowers who wish to hedge against rising interest rates. Money market investors who wish to protect against declining interest rates are natural sellers of FRAs.

FRAs are similar to exchange-traded interest rate futures contracts (Chapter 5) except that FRAs are over-the-counter (OTC) deals. As we have seen, an OTC derivative is a legal and binding agreement made directly between two parties. It cannot be freely traded and carries a potential counterparty risk - the risk that the other party might fail to fulfil its ...