What is Forward Rate Agreement?

What is Forward Rate Agreement?

An instrument that guarantees that a particular rate will be earned (or paid) during a specific future period is called a forward rate agreement. The agreement is worth zero when the guaranteed rate is the prevailing forward rate. This is because it is possible to enter into transactions that guarantee the forward rate for a future period. Suppose that a forward rate agreement ensures that a rate R will be earned for a particular future period when the forward rate is F . The value of the forward rate agreement is the present value of (R — F) applied to the principal amount. It is positive when R > F and negative when R < F.

The forward rate agreement has a positive value if the coupon is greater than the forward rate for the final period. In this case, the value of the cash flows after six months is less than their initial value because they are reduced by the value of this forward rate agreement. Similarly, the forward rate agreement has a negative value if the coupon is less than the forward rate for the final period. In this case, the value of the cash flows after six months is greater than their initial value.

Example of Forward Rate Agreement:

$ FRAP\, = \, \left ( \frac{\left ( R-FRA \right )\, \times \, NP\, \times \, P}{Y} \right )\, \times \, \left ( \frac{1}{1+R\, \times \, \left ( \frac{P}{Y} \right )} \right ) $

where:

FRAP = FRA payment
FRA = Forward rate agreement rate, or fixed interest rate that will be paid
R = Reference, or a floating interest rate used in the contract
NP = 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​

Company A enters into FRA with Company B, in which Company A receives a fixed (reference) rate of 4% on a principal amount of $5 million in a one-half year, and the FRA rate is set at 50 basis points below that rate. Company B will receive the one-year LIBOR rate on the principal amount, set in three years. The contract will be settled in cash at the start of the forward term, with an amount computed using the contract rate and the contract period as a discount.

Assume the following data, and plugging it into the formula above:

• FRA = 3.5%
• R = 4%
• NP = $5 million
• P = 181 days
• Y = 360 days

The FRA payment (FRAP) is thus calculated as:

$ FRAP\, = \, \left ( \frac{\left ( 0.04-0.035 \right )\, \times \, \$5million\, \times \, 181}{360} \right )\, \times \, \left ( \frac{1}{1+0.04\, \times \, \left ( \frac{181}{360} \right )} \right ) $

=$12,569.44 * 0.980285
=$12,321.64

Why is Forward Rate Agreement important?

It assists the parties in lowering the risk of future borrowing and lending due to unfavourable market fluctuations. FRA can also be used to trade and earn based on interest rate projections. They’re items that aren’t on the Balance Sheet. As a result, they have no bearing on financial ratios.