CFM13150 - Understanding corporate finance: derivatives: forward rate agreements

Forward rate agreements (FRAs)

A forward contract whose underlying asset is an interest rate is called a forward rate agreement. An FRA is a legally binding agreement between two parties to determine the rate of interest to be applied to a notional loan or deposit of an agreed amount. The agreement specifies the future date (the settlement date) when this notional loan or deposit is deemed to start, and how long it is to last.

A forward rate agreement (sometimes known as interest rate insurance) enables someone to borrow, or lend, money in the future at a guaranteed rate of interest. For an example of the use of a forward rate agreement, see CFM13300.

A company entering into a forward rate agreement, a forward foreign exchange contract or any other type of forward contract does not normally have to pay anything at the start of the contract. If it is receiving currency or some other asset in exchange, it will have to make a cash payment at maturity. In the case of a FRA, or other cash settled forward contract, it may receive cash, or it may have to pay it. Either way, the counterparty is exposed to a credit risk - the company may be unable to pay what it owes when the contract matures. The longer the period of the contract, the greater is the risk.

For this reason, a company will normally have to set up lines of credit before entering into any sort of forward contract. The costs of doing this means that smaller companies and start-up operations are less likely to use forward contracts than large groups of companies.

Another way of looking at an FRA is to consider it as an interest rate swap (see CFM13320) covering only one interest period. The difference between interest that would be payable at the agreed rate and at the then prevailing reference rate, say 3-months GBP LIBOR, is computed and discounted back to the settlement date, normally at the beginning of the period to which the contract relates.