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A forward rate agreement (FRA) is a contract between two parties and are traded over-the-counter (OTC). Both parties are effectively betting on future interest rates. FRAs are derivatives, i.e. the value of the FRA is derived from the underlying asset which in this case is the rate of interest. FRAs are similar to futures in as much as two parties agree on an amount, term of the contract, and contract initiation on a future date.

As with most financial contracts there is a buyer and a seller. If the interest rate rises above the rate defined in the contract (this rate is agreed by both parties), then the buyer is compensated by the seller. In other words, the buyer makes a profit. If interest rates fall then the buyer has to compensate the seller. This results in the seller profiting.

Guest post by  Accendo Markets

The buyers of this type of contract are usually trying to hedge against higher interest rates. The sellers on the other hand are usually trying to hedge against lower interest rates which both occur in the future.

Outlined below are the key properties of a FRA:

  1. Settlement date – Cash is paid at the beginning of the deposit.
  2. No need to borrow/lend -The buyer/seller does not need to borrow/lend
  3. Lock in rate – The rate is agreed by two parties and is then fixed
  4. Credit risk is low – Profits are only at risk if the other party defaults.
  5. Ability to cancel the contract – The contract can only be cancelled if agreed by the two parties.

How is the FRA settlement amount i.e. the compensation amount, calculated? Outlined below is the formula to calculate this value for both the seller and the buyer.

Sell-side:
((R-L)×D×A)/((D×L)+(B×100))

Buy- side:
((L-R)×D×A)/((D×L)+(B×100))

L=LIBOR rate
R=Rate defined in contract
A=agreed amount defined in contract
D=term of contract (measured in days)
B=Day basis (360 or 365 days)

It is important to note that the compensation value is issued at the start. In addition, the only risk is the compensation for both the buyer and seller. This is just a general formula. We can use the EURIBOR rate instead of the LIBOR rate which we can denote by E.

As with any financial instrument there are risks involved. One of the most obvious risks is interest rate risk. Higher/lower interest rates can cause a party to profit or loss. In addition there still remains a risk as to whether the other party will give compensation when it is due. It could be that the other party may default which may means that they are unable to pay the compensation.

CFDs, spread betting and FX can result in losses exceeding your initial deposit. They are not suitable for everyone, so please ensure you understand the risks. Seek independent financial advice if necessary. Nothing in this article should be considered a personal recommendation. It does not account for your personal circumstances or appetite for risk.