Forward Rate Agreement

Updated on January 3, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Forward Rate Agreement Meaning

Forward Rate Agreement, popularly known as FRA, refers to customized financial contracts that are traded Over the Counter (OTC) and allow the counterparties, primarily large banks, corporate to predefine interest rates for contracts that are going to start at a future date.

Two parties are involved in a Forward Rate Agreement: the Buyer and Seller. The Buyer of such a contract fixes the borrowing rate at the contract’s inception, and the seller fixes the lending rate. At the inception of an FRA, both parties have no profit/loss.

However, as time passes, the Buyer of the FRA benefits if Interest Rates increase than the rate fixed at the inception, and the Seller Benefits if the interest rates fall at the rate fixed at the inception. In short, the Forward Rate Agreement is Zero-sum gamesZero-sum GamesA zero-sum game refers to a competitive situation wherein the profit of one equals the loss of another and vice-versa, thereby nullifying the net change in wealth for participants involved. The number of participants can be anything but one. It is a type of game theory and often applies in economic and political situations. read more where the gain of one is a loss for the other.

Forward Rate Agreement Formula

The formula for calculating Forward Rate is as follows:

Forward Rate Agreement Formula = R2 + (R2 – R1) x [T1 / (T2 – T1)]

Forward-Rate-Agreement

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Forward Rate Agreements (FRA) Examples

However, there are multiple ways to calculate the same, which are discussed through the examples below.

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You can download this Forward Rate Agreement Excel Template here – Forward Rate Agreement Excel Template

Example #1

Let’s understand the Concept of FRA with the help of a few examples:

Current 30 day LIBOR rate: 4%

Current 120 day LIBOR rate: 5%

Let’s calculate the 30-day loan rate and 120-day loan rate to derive the equivalent 1/(n1-n2) – 1″ url=”https://www.wallstreetmojo.com/forward-rate-formula/”]forward rate”Forward”The, which will make the value of FRA equivalent to zero at inception:

Forward Rate Agreements Example 1-1
Forward Rate Agreements Example 1-2
Forward Rate Agreements Example 1-3
Forward Rate Agreements Example 1-4

Example #2

This is a 1X2 FRA Contract.

Let’s calculate the value of the Forward Rate Agreement in two scenarios:

  • At the beginning of the contract
Example 2
Example 2-1

Thus we can see at the beginning of the Forward Rate Agreement that there is no profit loss to any of the two parties.

Now let’s assume the rate falls to 3.5%, and let’s compute the value of FRA again:

Example 2-2

(Excel file attached)

Thus we can see that as interest rates move, the value of FRA changes again for one counterparty and equivalent loss to the other counterparty.

Example #3

Below are the details:

Example 3

(excel file attached)

Thus Rand Bank will receive USD 2.32 Mio from Flexi Industries.

Advantages of Forwarding Rate Agreement (FRA)

Disadvantages of Forwarding Rate Agreement (FRA)

Important Points

Conclusion

Forward Rate Agreement has customized Interest Rate contracts that are Bilateral, don’t involve any Centralized Counterparty, and are frequently used by Banks and Corporate.

This has guided what a forward rate agreement is, and its meaning. Here we discuss the examples of forwarding rate agreements along with their formula, advantages, and disadvantages. You can learn more about excel modeling from the following articles –

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