Forward rate agreements (FRAs) are over-the-counter contracts between parties that determine the interest rate to be paid on a date agreed in the future. A FRA is an agreement to exchange an interest rate commitment for a notional amount. The difference value of an FRA exchanged between the two parties, calculated from the point of view of the sale of a FRA (which mimics the receipt of the fixed interest rate), is calculated as follows:[1] where v n {displaystyle v_{n}} is the discount factor of the payment date on which the difference is physically settled, which, in modern price theory, will depend on the discount curve to be applied on the basis of the credit support annex (CSA) of the derivative contract. The lifespan of a FRA consists of two periods – the waiting or term time and the duration of the contract. The waiting period is the period until the start of the fictitious loan and can last up to 12 months, although terms of up to 6 months are the most common. The duration of the contract extends over the duration of the fictitious loan and can also last up to 12 months. As mentioned earlier, the settlement amount is paid in advance (at the beginning of the contract term), while interbank rates such as LIBOR or EURIBOR apply to late interest payments (at the end of the loan term). To account for this, the interest rate difference must be discounted, using the settlement rate as the discount rate. The amount of the settlement is thus calculated as the present value of the difference in interest: Two parties are involved in an appointment, namely the buyer and the seller. The buyer of such a contract sets the borrowing rate at the beginning of the contract and the seller sets the interest rate of the loan. When forming a FRA, both parties have no profit/loss. Forward settlement in foreign currency can be made in cash or delivery, provided that the option is acceptable to both parties and has been previously specified in the contract. Specifically, the buyer of FRA, who limits a fixed interest rate, is protected against an increase in interest rates and the seller who benefits from a fixed loan rate is protected against a decrease in interest rates.
If interest rates don`t go down or up, no one will benefit. FRA are money market instruments and are traded by both banks and companies. The FRA market is liquid in all major currencies, including the presence of market makers, and prices are also quoted by a number of banks and brokers. A FRA is a legally binding agreement between two parties. Usually, 1 of the parties is a bank specializing in FRA. Fra can be agreed as a contract by mutual agreement (OTC) with the parties concerned. However, unlike exchange-traded contracts such as futures, where the clearing house used by the exchange serves as a buyer to the seller and the seller`s buyer, there is significant counterparty risk when a party may not be able or willing to pay the liability at maturity. Interest rate futures (FRA) contracts are linked to short-term interest rate futures (STIR). 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 get their borrowing costs in order before interest rates rise too drastically. In addition, FRA are very flexible and billing dates can be tailored to the needs of those involved in the transaction. A forward interest rate is the interest rate for a future period. A forward rate contract (FRA) is a type of futures contract based on a specific forward rate and a reference interest rate, such as LIBOR, over a future time interval. A FRA is similar to a futures contract in that both have the economic effect of guaranteeing an interest rate. However, in a futures contract, the guaranteed interest rate is simply applied to the loan or investment to which it applies, while a FRA achieves the same economic effect by paying the difference between the desired interest rate and the market interest rate at the beginning of the contract term. FRA, like other interest rate derivatives, can be used to hedge interest rate risks, to gain speculation or to profit from arbitrage. The natural buyers of FRA are debtor companies that want to hedge against rising interest rates. Money market investors who want to protect themselves from falling interest rates are natural sellers of FRA. A FRA is a derivative instrument because its value is derived from spot or spot market interest rates, i.e. interest rates on deposits and loans that start now and not in the future. However, over time, the buyer of the FRA benefits when interest rates exceed the interest rate set at the beginning, and the seller benefits when interest rates fall below the interest rate set at the beginning.
In short, the forward rate agreement is a zero-sum game where the victory of one is a loss for the other. In other words, a forward rate contract (FRA) is a tailor-made, over-the-counter financial futures contract on short-term deposits. An FRA transaction is a contract between two parties for the exchange of payments on a deposit, the so-called nominal amount, which must be determined on the basis of a short-term interest rate called the reference interest rate over a period of time predetermined at a future date. FRA transactions are recorded as a hedge against changes in interest rates. The buyer of the contract secures the interest rate in order to protect himself from an increase in the interest rate, while the seller protects himself against a possible fall in interest rates. At maturity, no funds exchange hands; On the contrary, the difference between the contracted interest rate and the market interest rate is exchanged. The buyer of the contract will be paid if the published reference interest rate is higher than the contractually agreed fixed price, and the buyer will pay the seller if the published reference interest rate is lower than the contractually agreed fixed price. .