Does the term Forward Rate Agreement sound familiar to you? We give you a clue: it is a type of contract. If you work in the economic area of a company, you may know this concept. If not, you’re in luck because we’ll tell you about it in this post.
Forward Rate Agreements ( FRA) are agreements between two parties that determine the interest rate to be paid at an agreed future date. It is an over-the-counter (OTC) contract, meaning it is traded directly between the parties and not on a centralized exchange.
Characteristics of Forward Rate Agreement Contracts
Understanding the framework of Forward Rate Agreement contracts can be complicated. Therefore, we share with you some characteristics and components of these contracts that shed some light on the way. Go for it!
- Interest Rate Agreement: The FRA establishes an agreement between two parties to exchange future cash flows based on predetermined interest rates.
- Start and expiration date: The contract marks both the start date and the expiration date of the agreement.
- Principal and interest rate: the principal on which the cash flows will be calculated and the interest rate at which these calculations will be applied are specified.
- Reference rate and agreed rate: The contract includes a reference rate (for example, LIBOR) and an agreed rate. The agreed rate is the rate at which the parties agree to exchange cash flows on the maturity date.
- Net Payments: On the contract expiration date, one party will make a net payment to the other, depending on whether the reference rate is higher or lower than the agreed rate.
- Flexibility: FRA contracts can be flexible in terms of the length of the agreement, the size of the principal, and the frequency of settlement.
- Cash settlement: FRAs are settled in cash, that is, there is no physical exchange of principal, but cash flows are adjusted according to differences between the reference rate and the agreed rate.
Regarding the use of FRA contracts, they are mainly used by financial institutions and companies to hedge against the risk of changes in interest rates. For example, a company that expects to have to borrow in the future can use an FRA to ensure that it will not be affected by an unexpected increase in interest rates.
Settlement of Forward Rate Agreement contracts
Settlement, in the financial context, refers to the process by which financial transactions are completed. In the case of FRA contracts, settlement of FRA contracts occurs on the contract expiration date. Such settlement can occur in several ways, depending on whether the reference rate on the maturity date is higher or lower than the rate agreed in the contract.
Here are two main liquidation scenarios:
- Reference rate higher than the agreed rate (superior variable rate): in this case, the party that has purchased protection ( FRA buyer ) receives a net payment from the seller.
- Reference rate lower than the agreed rate (lower variable rate): Here, the party who has sold protection (FRA seller ) receives a net payment from the buyer.
Positions in an FRA agreement: buying and selling party
Before we have mentioned two crucial parts of the FRA agreement. We refer to the position of buyer and seller. Understanding the function of each will help you have more clarity about how the contract works and how settlement is determined.
Specifically, the buy-side is the one that purchases protection against the risk of rising interest rates. You agree to pay the difference between the market reference rate on the maturity date and the rate agreed in the contract if the reference rate is higher than the agreed rate.
For its part, the selling party is the one who offers protection against the risk of lower interest rates. Contrary to the previous case, you agree to pay the difference between the rate agreed in the contract and the market reference rate, if the reference rate is lower than the agreed rate.
Advantages of Forward Rate Agreement contracts
Finally, it is important to know the advantages of these contracts for institutions seeking to manage and mitigate their exposure to interest rate risk. Take note!
- Hedging: FRAs provide an effective way to hedge against the risk of adverse interest rate fluctuations. Parties can lock in a future interest rate through an FRA, allowing them to protect against unfavourable movements in interest rates.
- Flexibility: They are flexible in terms of duration, amount and start date. This allows parties to tailor contracts to their specific needs and align them with their risk management strategies.
- Preserving Borrowing Capacity: By locking future interest rates through FRA, parties can protect their borrowing capacity against potential increases in interest rates.
- Interest rate risk management: They allow financial institutions and companies to proactively manage their interest rate risk.
- Reducing financial volatility: Parties can reduce volatility in their financial results and improve the stability of their business operations.
If you are interested in this topic, you can read more about how financial markets work or about strategies to create a company’s economic plan. We invite you to subscribe to Educa.Pro and enjoy, starting today, a wide range of specialized training offers without any limits!