A forward rate agreement, commonly referred to as an FRA, is a financial instrument used to hedge against interest rate risk. Specifically, an FRA is a contract between two parties, in which one party agrees to pay the other party a fixed rate of interest on a notional amount for a specific period of time in the future. In exchange, the other party agrees to pay the first party a floating rate of interest over the same period.
The forward rate in an FRA refers to the fixed rate of interest that will be paid by one party to the other. This rate is typically determined at the time the contract is entered into, based on the prevailing market rates for similar financial instruments. The notional amount of the FRA is the amount upon which the fixed rate of interest is calculated, but it is not actually exchanged between the parties.
The purpose of an FRA is to manage interest rate risk. For example, a borrower who expects to incur debt at a future date may be concerned that interest rates will rise in the interim, increasing their borrowing costs. By entering into an FRA, the borrower can lock in a fixed rate of interest for the future, providing a measure of certainty and protection against rising rates.
Similarly, a lender may be concerned that interest rates will fall in the future, reducing their returns on lending. In this case, the lender can enter into an FRA with a counterparty to protect against the risk of falling interest rates. The FRA essentially provides the lender with a guaranteed minimum rate of return on their lending.
Overall, forward rate agreements are a useful financial instrument for managing interest rate risk. They are particularly useful for borrowers and lenders who have a need to manage their exposure to interest rate movements. By locking in a fixed rate of interest for a specific period of time, parties can gain greater certainty and control over their financial outcomes.