Forward Rate Agreement (FRA)

A forward rate agreement (FRA) is a contract between two parties that fixes the interest rate for a future borrowing or lending period. No money is lent under the contract itself. Instead, on the start date of that future period, the parties compare the agreed rate with the market reference rate and one pays the other the difference, calculated on a notional amount. Banks, corporate treasurers and fund managers use FRAs to lock in short-term rates or to take a view on where rates are heading.

An FRA is one of the simplest interest rate derivatives. It is the interest rate cousin of a currency forward contract and the single-period building block of an interest rate swap, which can be seen as a string of FRAs. FRAs are traded over the counter under ISDA documentation, while exchange-traded short-term interest rate futures provide a standardised alternative.

Picture a company that knows it will need to borrow money in three months for three months, and worries that rates will rise before then. It strikes a deal with a bank today: "If rates are above 4% when the time comes, you pay me the difference; if they are below 4%, I pay you." Whatever happens, the company's effective cost ends up close to 4%.

It works like agreeing a price with a builder before materials costs change. The company still borrows from its usual lender at the market rate; the side agreement simply evens out any surprise.

FRAs are quoted by their start and end months. A "3×6" FRA covers a three-month period that begins in three months and ends in six; a "6×12" covers six months starting in six months. The buyer of an FRA pays the fixed rate and receives the floating rate, so it gains if rates rise; this is the borrower's hedge. The seller receives fixed and gains if rates fall; this is the depositor's or lender's hedge.

The key dates are the trade date, the fixing date (when the reference rate is observed), the settlement date (the start of the contract period, when cash changes hands) and the maturity date. Because settlement happens at the start of the period, but the interest difference relates to the whole period, the payment is discounted back.

The cash settlement paid to the FRA buyer is:

• $S$ is the settlement amount; a negative value means the buyer pays the seller.
• $N$ is the notional amount.
• $L$ is the reference rate observed on the fixing date.
• $K$ is the fixed rate agreed in the FRA.
• $\tau$ is the length of the contract period as a fraction of a year, for example days divided by 360.

A treasurer buys a 3×6 FRA on 10,000,000 at 4.00%. On the fixing date the three-month reference rate is 4.50%, and the period is 90 days, so $\tau = 0.25$. The undiscounted difference is $10{,}000{,}000 \times 0.005 \times 0.25 = 12{,}500$. Dividing by $1 + 0.045 \times 0.25 = 1.01125$ gives a settlement of about 12,360.94 paid to the treasurer. The treasurer then borrows at the market rate of 4.50%, but the FRA payment offsets the extra half point, leaving an effective cost close to 4.00%.

The fair rate on an FRA is the forward rate implied by today's spot rates for the two dates. If the three-month rate is 4.0% and the six-month rate is 4.2%, borrowing for six months must cost the same as borrowing for three months and rolling over, so the implied three-month rate starting in three months works out at about 4.36% using simple interest. Forward rates are derived from the zero-coupon yield curve, which is in turn built from instruments such as zero-coupon bonds and futures. FRA rates therefore reflect market expectations of central bank decisions, plus a term premium. Traders read them closely, alongside federal funds futures, to gauge how many rate changes markets expect.

• Hedging borrowing costs. A company with a floating rate note or bank loan can buy FRAs to fix the rate on upcoming resets, converting part of its debt to a fixed interest rate for a period. This is a direct form of hedging against interest rate risk.
• Managing bank gaps. Banks use FRAs to close mismatches between the reset dates of their assets and liabilities.
• Taking views. Because no principal changes hands, FRAs allow speculation on short-term rates with little upfront cash.

For decades FRAs were fixed against LIBOR and similar term interbank rates. With USD LIBOR panels ending in June 2023 and the move to overnight rates such as SOFR, which are calculated in arrears rather than known at the start of a period, the classic FRA structure became less convenient. Much of the activity moved to SOFR futures, overnight index swaps and other swaps, though FRAs remain in use in currencies that kept term benchmarks, such as EURIBOR in euros.

Being bilateral contracts, FRAs carry counterparty risk: if the losing party defaults, the winner is not paid. Exposures are limited because only the interest difference is at stake, not the notional, and many FRAs are now cleared through a central counterparty with daily margin. Reporting and clearing rules introduced after the 2008 financial crisis cover FRAs in the US, EU and UK.

• International Swaps and Derivatives Association (ISDA)
• Bank for International Settlements: OTC derivatives statistics