Explanation of a Forward Rate Agreement

A forward rate agreement is an option contract that involves betting on interest rates or exchange rates. It is a fairly sophisticated model mostly employed by institutional investors such as banks, lenders, hedge funds or private equity groups. In this type of agreement, the contract provides one interest rate to be paid or received at a future date. The difference between this rate and the realized rate is paid to the party who is "in the money" at the end of the option. There are, then, two rates: the notional rate on the agreement and the floating, or market, rate.

Forward Rate Agreement Example

A forward rate agreement (FRA) may seem complicated, but an example will help illuminate the simplicity of the concept. A borrower, John, set up an FRA for a fixed rate of 2 percent on a $1,000 loan over 2 years. Jack agreed to pay that 5 percent, but Jack asked John to pay him a rate equal to the national prime interest rate, which floats over time. At the end of the 2-year period, the national prime rate average was 2.3 percent. This means John actually owed Jack money; in fact, he owed the difference between the 2 percent interest and 2.3 percent interest on the loan. The total amount owed was only $30, but this could easily be representative of a large chunk of change on bigger contracts. 

Purpose of a Forward Rate Agreement

In this example, John agreed to loan Jack $1,000 and to accept 2 percent interest. He did this thinking 2 percent would be higher than the national prime interest rate and that he would therefore earn a profit on the loan. Unfortunately, he bet wrong, and he ended up losing cash on the loan. If the opposite had occurred, John would have been able to hedge against the risk that the national prime rate might drop by keeping his rate fixed at the high 2 percent. This is a strategy used by lenders and investors to protect the sums they are lending.

Forward Rate Agreement on Currencies

If the scenario is applied to currencies, the same principle of two separate rates is still applied. In this case, Jack gave John $1,000 euro for $1,200 USD, or a 120 percent rate. The two signed a contract setting up a floating rate on the FRA to be the realized exchange rate. At the end of the year, the realized exchange rate was 130 percent. Since the rate was lower than the notional rate, John owed Jack another $100 on the contract. This is the difference between the 120 percent and 130 percent rates, or the ratio of the currency exchange rates. Jack was protected in the contract because he was guaranteed to receive at least the 120 percent exchange. This type of exchange is common for large corporations looking to hedge against the risk they will receive unfavorable exchange rates by setting up a fixed exchange rate through an FRA.

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