how forward rate agreements work
fras typically involve two parties exchanging a fixed interest rate for a variable one the party paying the fixed rate is the borrower or long side while the party paying the variable rate is the lender or short side people enter into an fra wanting to lock in an interest rate if they believe rates are likely to rise as such they want to fix their borrowing costs today through the agreement suppose the u s federal reserve is likely to hike u s interest rates in a monetary tightening cycle companies would then want to fix their borrowing costs before rates rise too dramatically fras are very flexible and settlement dates can be tailored to the needs of those involved in the transaction the cash difference between the fra and the reference rate or floating rate is settled on the value date or settlement date 1formula and calculation for a forward rate agreement fra frap r fra n p p y 1 1 r p y where frap fra payment fra forward rate agreement rate or fixed interest rate that will be paid r reference or floating interest rate used in the contract n p notional principal or amount of the loan that interest is applied to p period or number of days in the contract period y number of days in the year based on the correct day count convention for the contract begin aligned text frap left frac r text fra times np times p y right times left frac 1 1 r times left frac p y right right textbf where text frap text fra payment text fra text forward rate agreement rate or fixed interest text rate that will be paid r text reference or floating interest rate used in text the contract np text notional principal or amount of the loan that text interest is applied to p text period or number of days in the contract period y text number of days in the year based on the correct text day count convention for the contract end aligned frap y r fra np p 1 r yp 1 where frap fra paymentfra forward rate agreement rate or fixed interestrate that will be paidr reference or floating interest rate used inthe contractnp notional principal or amount of the loan thatinterest is applied top period or number of days in the contract periody number of days in the year based on the correctday count convention for the contract suppose company a enters into an fra with company b in which company a will receive a fixed reference rate of 4 on a principal amount of 5 million in half a year and the fra rate will be set at 50 basis points less than that rate in return company b will receive the one year term secured overnight financing rate sofr determined in three years on the principal amount the sofr is an influential interest rate banks use to price u s dollar denominated derivatives and loans the daily sofr is taken from the treasury repurchase market where investors offer banks overnight loans backed by their bond assets term sofr is a forward looking rate providing a term structure for sofr to be used in floating rate loans and notes the agreement will be settled in cash at the beginning of the forward period discounted by an amount calculated using the contract rate and period the formula for the fra payment takes into account these five variables assume the following data and plug these numbers into the formula above the fra payment frap is thus calculated as frap 0 04 0 035 5 million 181 360 1 1 0 04 181 360 12 569 44 0 980285 12 321 64 begin aligned text frap left frac 0 04 0 035 times 5 text million times 181 360 right quad times left frac 1 1 0 04 times left frac 181 360 right right 12 569 44 times 0 980285 12 321 64 end aligned frap 360 0 04 0 035 5 million 181 1 0 04 360181 1 12 569 44 0 980285 12 321 64 if the payment amount is positive then the fra seller pays this amount to the buyer otherwise the buyer pays the seller remember the day count convention is typically 360 days in a year note also that the notional amount of 5 million is not exchanged instead the two companies involved in this transaction use that figure to calculate the interest rate differential forward rate agreement fra vs interest rate futuresfras are different from interest rate futures though both are derivatives based on the expectation of future interest rates the main difference between fras and interest rate futures lies in their level of customization as otc contracts fras can be made to the parties specifications the terms of the agreement such as the notional amount fixed interest rate and settlement date can be tailored to meet the specific needs of the counterparties 3by contrast interest rate futures are standardized contracts traded on exchanges they have fixed contract sizes expiration dates and other terms which makes them less adaptable to unique hedging requirements however this standardization also makes interest rate futures more liquid and easier to trade since fras are private agreements between two parties each party is exposed to the risk that the other may default on their obligations this means that the creditworthiness of the counterparty is a crucial consideration in fra transactions 1interest rate futures meanwhile are traded through exchanges which act as the intermediary between buyers and sellers the exchange clearing house guarantees the contracts significantly reducing counterparty risk for traders the settlement processes for fras and interest rate futures also differ fras are typically settled in cash at the end of the contract term with the payment based on the difference between the agreed upon fixed rate and the prevailing market rate interest rate futures are marked to market daily meaning that gains and losses are realized on a daily basis moreover because interest rate futures are exchange traded they are subject to greater regulatory oversight than fras this increased regulation provides more transparency and reduces the risk of default limitations of forward rate agreementsthe downside of fras is the risk borrowers face if the market rate has moved adversely causing the borrower to take a loss on the cash settlement the fra also has lower levels of regulation and oversight related to the transaction compared with futures contracts it can sometimes be difficult for a party to close an fra before the maturity date and the agreements are also subject to counterparty risk as there is a potential that a contract participant could default 