# What Is Forward Rate Agreement with Example

Suppose there is a 2 *5 FRA (2 months after for a period of 3 months) on a fictitious amount of \$50,000 at an interest rate of 5%. In this case, the settlement date is after 2 months based on the 60-day LIBOR. As a hedge vehicle, FRAs are similar to short-term interest rate futures (ITRs). However, there are a few differences that set them apart. Fra determines the rates to be used, as well as the date of termination and the nominal value. FRA are settled in cash with the payment based on the net difference between the contract interest rate and the market variable interest rate, called the reference rate. The nominal amount is not exchanged, but a cash amount based on exchange rate differences and the nominal value of the contract. Let`s calculate the interest rate of the 30-day loan and the rate of the 120-day loan to calculate the equivalent term interest rate, which makes the value of FRA zero at the beginning: If the FRA interest rate is higher than the LIBOR rate, the borrower must pay the lender the difference in the interest rate. And if the FRA rate is lower than the LIBOR rate, the borrower could actually receive money at a rate below the market rate. It should be noted that the payment ultimately only compensates for changes in the interest rate after the contract date. There is no participation of the principal amount.

Rate futures (FRA) contracts are associated with short-term interest rate futures (STIR futures). Since STIR futures are set against the same index as a subset of FRA, the FRA IMM, their price is interdependent. The type of each product has a distinctive gamma profile (convexity) that results in rational and non-arbitrage price adjustments. This adjustment is called a forward convexity adjustment (FCA) and is usually expressed in basis points.  Here are the details of forward rate agreements: The format in which FRAs are scored is the term until the settlement date and the term until the maturity date, both expressed in months and generally separated by the letter “x”. This means that the parties can customize it according to their needs. In general, a FRA depends on the LIBOR set. For example, if the Federal Reserve is about to raise U.S. interest rates, which is called a monetary tightening cycle, companies will likely want to get their borrowing costs in order before interest rates rise too drastically. In addition, FRA are very flexible and billing dates can be tailored to the needs of those involved in the transaction. A forward rate contract (FRA) is ideal for an investor or company that wants to set an interest rate. They allow participants to make a known interest payment at a later date and receive an unknown interest payment.

This helps protect investors from the volatility of future interest rate movements. By entering into a FRA, the parties agree on an interest rate for a specified period of time, starting from a future date, on the basis of the principal amount indicated at the beginning of the contract. Forward rate contracts (FRUs) are similar to futures contracts in which a party agrees to borrow or lend a certain amount of money at a fixed interest rate at a predetermined future date. Let`s understand the concept of FRA with the help of a few examples: there is a risk for the borrower if he were to liquidate the FRA and the interest rate on the market had moved negatively, so that the borrower would suffer a loss on the cash settlement. FRA are highly liquid and can be settled in the market, but a cash flow difference between the FRA rate and the prevailing market rate is compensated. An appointment rate agreement is different from an appointment contract agreement. A currency futures transaction is a binding contract in the foreign exchange market that sets the exchange rate for buying or selling a currency at a future date. A currency futures transaction is a hedging instrument that does not involve advance payment. The other great advantage of a currency futures transaction is that, unlike standardized currency futures, it can be tailored to a certain amount and delivery time. In principle, the parties to the FRA agree on a certain interest rate, which starts from a future date for a certain period of time.