Two parties can agree to predetermine an interest rate obligation for a future payment. The agreement is made on the forward rate, hence the name Forward Rate Agreement (FRA).
FRAs are over-the-counter instruments that can be arranged by two parties directly. FRAs can be used in interest rate hedging planning. FRAs are particularly useful in changing interest rate environments where the borrowers predict an increase in the interest rates in the future.
What is a Forward Rate Agreement (FRA)?
A forward rate agreement (FRA) is an agreement between two parties for a loan or deposit with an agreed fixed interest rate for a future date. The borrower and lender can agree upon the future interest rate with a notional amount for the loan or deposit.
Both parties must settle the contract amount at a specified future date. Both parties settle only the difference of net cash flows and the notional amount, or the principal amount is not exchanged.
Borrowers and lenders can enter an FRA with customized features and mutually agreed-upon future dates.
How Does a Forward Rate Agreement Work?
Forward rate agreements can have a maturity of any timeframe. Most commonly, FRAs are arranged for up to two or five years of maturity. Borrowers enter an FRA if they anticipate an increase in the interest rates in the future.
Lenders will enter an FRA if they predict a fall in the interest rates. Hence, a gain of one party would result in the loss of another party in an FRA. Both parties would settle only the difference of net cash flow due to a difference in the FRA and the market rate on the transaction date.
Forward rate agreements can also be arranged for fixed deposits with the banks. If the depositor fears a fall in the interest rate. The depositor would enter an FRA locking a higher interest rate for a specified future date.
Forward rate agreements must be settled by both parties on the specified date. As these agreements are OTC instruments, there is always a credit risk for either party with an FRA. Similarly, FRAs also carry interest rate risks as they can move in either direction. In an FRA, only one party would succeed usually. If the interest rates stay near the prevailing interest rates, then both parties would remain even.
Example
Suppose it is July 1, 2021, and the current interest rate on a short-term bank loan is LIBOR + 2%. The current LIBOR is 3%, hence the total cost of borrowing is 5%. A borrower anticipates an increase in the LIBOR in the coming days. The borrower needs to make a $ 2 million payment on December 1, 2021.
Let us assume two scenarios of interest rate movements and see if entering a 3-6 FRA can benefit the borrower or not.
Scenario 1:
Suppose the borrower was right and the LIBOR increases suddenly to 5% hence the total cost rises to 7%. The FRA starts in 3 months and comes with a 6-month maturity.
Borrowers bank loan payment for 7% interest rate= (2 × 7%) × 3/12
Loan Payment = $ 30,000
FRA Compensation receivable = [2 × (7-5%)] × 3/12
FRA Compensation receivable = $ 10,000
Net Loan Amount Payable = $ 20,000.
Scenario 2:
Now suppose the borrower predicted wrongly and the LIBOR decreases suddenly to 1% hence the total cost falls to 3%. The FRA starts in 3 months and comes with a 6-month maturity.
Borrowers bank loan payment for 3% interest rate= (2 × 3 %) × 3/12
Loan Payment = $ 15,000
FRA Compensation receivable = [2 × (3-5%)] × 3/12
FRA Compensation Payable= $ 10,000
Net Loan Amount Payable = $ 25,000.
As we can see the borrower lowered the borrowing cost with an FRA when interest rates increased. At the same time, the borrower had to forego an opportunity cost when the interest rate decreased.
Advantages of Using a Forward Rate Agreement
Forward Rate Agreements can bring benefits to both lenders and creditors.
- Both parties can lock in the interest rates to protect themselves against adverse interest rate movements.
- FRAs protect both parties from interest rate risks.
- FRAs are OTC instruments, hence can be customized and modified according to the needs of both parties.
- FRAs can be used for interest rate hedging and speculations.
Disadvantages of Using a Forward Rate Agreement
Using forward rate agreements can bring some limitations as well.
- FRAs carry a credit risk for both parties in the agreement.
- FRAs are OTC instruments, hence closing the contract in an adverse situation can be difficult.
- Both parties can bear opportunity costs by foregoing favorable interest rate movements.
Final Thoughts
Forward Rate Agreements can protect lenders and borrowers from interest rate risks. Both parties can lock in interest rates for a specified future period. However, FRAs are OTC instruments hence bring credit risk and reinvestment risks for both parties.
