Forward Rate Agreement

An Forward Rate Agreement (FRA) is an agreement between two parties regarding the value or level of a financial instrument at a future date.

Unlike futures, FRAs are not traded on an exchange (This is called OTC, or Over The Counter).

Forward Rate Agreements are flexible, as they can be structured to mature on any date.

In general FRAs are traded on the future level of 3 or 6 month Libor.

The FRA does not involve any transfer of principal. It is settled at maturity in cash, representing the profit or loss resulting from the difference in the agreed rate (FRA rate) and the settlement rate at maturity.

EXAMPLE
The current 3 v 6 FRA is 6.40%. This means the market is implying that in 3 mths, 3 mth Libor will be 6.40% (A 3 v 9 FRA is trading the implied 6 mth Libor rate in 3 mths time).

Should a corporate believe that 3 mth Libor will be higher than 6.40% in 3 mths, they could enter into an FRA at 6.40% on a prescribed notional where they will profit if Libor is HIGHER than 6.40% and lose if it is LOWER.
FRAs can be used by borrowers to hedge floating rate settings on loans, and by investors to hedge floating rate settings on assets.

PRICING
The FRA rate is the implied forward rate for that date. The value of the FRA will be dependent on the then market view of future rates. The shape of the yield curve is very important in establishing value. See the "Implied Forwards" section for more detail.

TARGET MARKET
FRAs are an attractive instrument for both borrowers and investors who wish to take a view on the future level of short term interest rates. As they are date specific, they are an ideal instrument for hedging future rate settings on loans and financial assets.

ADVANTAGES
· Customized dates and amounts
· Very liquid market so small Bid/Offer spreads
· No premiums or payments upfront
· Can be reversed at any time at the then prevailing rate

DISADVANTAGES
· Only cover short term interest rates