Forward Rate Agreements (FRA’s) are similar to over-the-counter futures contracts (but there is no margin) or single-period swaps.
One party contracts with another for a fixed rate that applies to a future period. The buyer receives a payment if market rates exceed the contract rate, but must pay the seller if market rates fall below the contract rate.
For example, hedging a six-month period, that will commence in three months from the contract date, is called a “three against nine” FRA, or 3×9 FRA. In three months, the payment is determined by comparing the contract rate to current market rates.
Unlike swaps and caps, where the payment is determined at the outset of each period but settled in arrears, FRA payments are discounted and paid at the beginning of the period.
The payment ends up compensating for any change in interest rates since the contract date.
FRA’s are generally used to lock in an interest rate for transactions that will take place in the future. For example, a bank that plans to issue or roll over certificates of deposit, but anticipates that interest rates are headed upward, can lock in today’s rate by purchasing FRA. If rates do rise, then the payment received on the FRA should offset the increased interest cost on the CDs. If rates fall, the bank pays out
Under the FRA but has a lower cost on its debt. In either case, the all-in cost of the CDs is relatively the same. The same example holds true for a corporation that plans to issue or roll over commercial paper.
The above example demonstrated how FRA’s were used to lock in an interest rate or debt cost. FRA’s can also be used to lock in the price of a short-term security to be taught or sold in the near future.
- If the investment is being purchased, you can hedge the risk that interest rates may fall (which would increase the price of the investment) by selling the FRA.
- If the investment is being sold, you can hedge against the risk of rates rising (which would depress the sales price of the security) by buying the FRA.
Benefits of FRAs
- Used similar to futures
- But, no margin and no daily settlements
Shortcomings of FRAs
- Credit risk of counterparty
- Short-term nature