What is a Forward Rate Agreement (FRA)
FRA is an agreement between two parties (financial institution and its client) which guarantees that the client will be able to deal at an agreed rate of interest for a future period for a notional amount. FRA with a tenor ” 3 against 6″ is an agreement covering the three month from spot, while one which covers the six months period beginning six month from now is known as a ” 6 against 12″ FRA.
No exchange of principal as gains losses resulting from the difference between agreed or contracted of interested and market rate level for that tenor (LIBOR) on fixing date which can be payable or receivable.
A client buys the FRA to be protected against rising interest rates and sell a FRA to be protected against falling interest rate movements.
It can be a useful hedging tool for short periods.
As FRA is an interest rate risk management tool, it will allow corporate to manage future interest rate obligations at the same time to be protected against future adverse interest movements.
Risk and Rewards
FRA’s are done to cover short term interest rates. When buying FRA’s if LIBOR lower on fixing date, or in the case of selling.
FRA’s if LIBOR is higher on the fixing date, then the FRA transaction will settled at a loss.
Customized dates and amounts to match customer needs, also no premiums or payments upfront.
Clients can manage or hedge interest rate exposure using FRA’s as the effective rate of interest is determined at the time the contract entered into.
How FRA’s work
Consider Terrastone Finance Services client is looking to borrow USD 10 million for 6 months in a 3 month time.
Expectations that interest rates might increase over the next 3 months. Client, to fix his 6 month borrowing.
Current market rate is at 6% p.a. The decision maker will buy a 4 against 9 month FRA agreement to cover exposure which will be fixed at 6.5% for 6 month, starting in 3 month time (Click here for details).
FRA’s can be offered in all major currencies and are excellent off -balance sheet product which can provide corporate with added flexibility in the their financial operations. Also, provide protection against future interest rate for known or likely liquidity requirements.