Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options

Chapter 3. Forward Rate Agreements

INTRODUCTION

A forward rate agreement (FRA) is a bilateral contract fixing the rate of interest that will apply to a notional principal sum of money for an agreed future time period. In fact the notional principal never changes hands. It is simply used to calculate the compensation or settlement amount that is paid by one party to the other. One side is said to be the buyer and the other the seller.

• Buyer. The buyer of the FRA is compensated in cash by the seller if the reference or benchmark interest rate for the contract period turns out to be above that agreed in the contract.

• Seller. The seller of the FRA contract is compensated by the buyer if the benchmark interest rate turns out to be below the contractual rate.

The natural buyers of FRAs are corporate borrowers who wish to hedge against rising interest rates. Money market investors who wish to protect against declining interest rates are natural sellers of FRAs. An FRA is a derivative instrument because its value is derived from spot or cash market interest rates, that is, the interest rates on deposits and loans starting now rather than in the future.

FRAs are very similar to the short interest rate futures contracts traded on the exchanges (Chapter 5) except that FRAs are over-the-counter (OTC) transactions. As we have seen, an OTC derivative contract is a legal and binding agreement made directly between two parties. As such it cannot be freely traded and carries a counterparty risk – the ...