Forward-Rate Agreement (FRA)

Overview

A Forward-Rate Agreement (FRA) is a financial contract between two parties to exchange interest payments on a pre-determined principal amount at a future date. These agreements allow parties to hedge against the risk of interest rate fluctuations by locking in a specific interest rate for a future period.

FRAs are commonly used by financial institutions and corporations to manage their interest rate risk exposure by fixing borrowing or lending rates in advance.

Key Characteristics

Interest Rate Determination: The primary function of an FRA is to set an interest rate that will apply to a future loan or deposit.
Specified Currency: The agreement involves a specified amount of a particular currency.
Future Date: The rate of interest is agreed upon for a future date, even if the underlying loan or deposit may not materialize.

Examples

Interest Rate Hedge for Borrowers: A corporation expecting to take a loan in six months can enter into an FRA to lock in the interest rate now. This helps the corporation avoid the risk of rising interest rates.
Depositors’ Hedge: An investor expecting to deposit a large sum of money in the future can use an FRA to secure an advantageous interest rate, thus eliminating the uncertainty about future deposit rates.

Frequently Asked Questions (FAQs)

What Is the Main Purpose of a Forward-Rate Agreement (FRA)?

The main purpose of an FRA is to hedge against interest rate risk by locking in a specific future interest rate for borrowing or investing.

Who Typically Uses FRAs?

Financial institutions, corporations, and investors typically use FRAs to manage interest rate exposure.

How Is the Settlement Amount Calculated in an FRA?

The settlement amount is the difference between the agreed interest rate and the prevailing market rate at the contract’s settlement date, applied to the notional principal amount and discounted to present value.

Can an FRA Be Used to Speculate on Interest Rate Movements?

Yes, while primarily used for hedging, FRAs can also be used by traders to speculate on interest rate movements.

What Happens If the Market Interest Rate Differs from the Contracted Rate in an FRA?

If the market rate differs from the contracted rate, one party will pay the other the difference, settled at the contract’s settlement date.

Interest Rate Swap

An agreement between two parties to exchange interest payments on a certain principal amount over a specified period, typically exchanging fixed-rate payments for floating-rate payments.

Forward Contract

A customized contract between two parties to buy or sell an asset at a specified future date for a price agreed upon today.

Hedging

A risk management strategy used to offset potential losses in investments by taking an opposite position in a related asset.

Futures Contract

A standardized contract to buy or sell a specific quantity of a commodity or financial instrument at a specified price with delivery scheduled at a predetermined future date.

Online References

Suggested Books for Further Studies

“Options, Futures, and Other Derivatives” by John C. Hull
“Interest Rate Markets: A Practical Approach to Fixed Income” by Siddhartha Jha
“Understanding Derivatives: Markets and Infrastructure” by the Federal Reserve Bank of Chicago
“Quantitative Risk Management: Concepts, Techniques, and Tools” by Alexander J. McNeil

Accounting Basics: “Forward-Rate Agreement (FRA)” Fundamentals Quiz

### What type of risk does an FRA primarily help to hedge against? - [ ] Credit Risk - [ ] Liquidity Risk - [ ] Operational Risk - [x] Interest Rate Risk > **Explanation:** A Forward-Rate Agreement (FRA) is primarily used to hedge against interest rate risk by locking in a specific rate for a future period. This helps users protect themselves from the uncertainty of future interest rate movements. ### Who are the typical users of FRAs? - [ ] Local Governments - [x] Financial Institutions - [ ] Real Estate Brokers - [ ] Individual Homeowners > **Explanation:** FRAs are typically used by financial institutions, corporations, and investors to manage exposure to interest rate fluctuations. These agreements provide a tool to hedge against potential interest rate changes. ### What is the basis of the settlement amount calculation in an FRA? - [ ] Actual Exchange of Principal - [ ] Future Spot Rate of Currency - [x] Difference Between Agreed and Market Interest Rates - [ ] Average Historical Interest Rates > **Explanation:** The settlement amount in an FRA is calculated based on the difference between the agreed interest rate and the prevailing market interest rate at the time of settlement. There is typically no exchange of principal. ### When entering into an FRA, what do parties agree upon? - [x] A specific interest rate for a future period - [ ] A loan amount to be disbursed immediately - [ ] An equity investment return rate - [ ] A commodity price for future delivery > **Explanation:** In an FRA, parties agree on a specific interest rate that will apply to a notional loan or deposit during a future period. This allows for the hedging of future interest rate risks. ### How does an FRA impact a borrower expecting interest rate increases? - [ ] No Impact - [ ] Increases Borrowing Costs - [x] Locks in Borrowing Costs - [ ] Provides Immediate Funds > **Explanation:** An FRA locks in borrowing costs for future periods, which can protect a borrower from potential interest rate increases. This helps stabilize financial planning and budgeting. ### In an FRA, what happens if the actual interest rate at settlement is higher than the agreed rate? - [x] The seller compensates the buyer - [ ] The buyer compensates the seller - [ ] No compensation occurs - [ ] Both parties share the gain equally > **Explanation:** If the actual interest rate is higher than the agreed rate, the seller of the FRA compensates the buyer the difference. This provides the hedging benefit to the buyer. ### What does the term "notional principal" refer to in an FRA? - [ ] Actual Money Transferred - [x] Hypothetical Amount Used for Calculations - [ ] Amount Contributing to Overheads - [ ] Total Amount Transacted > **Explanation:** The notional principal in an FRA refers to the hypothetical amount used solely for calculating interest payments. This principal is not actually exchanged between the parties. ### Which type of agreement is an FRA most similar to? - [ ] Stock Option - [ ] Commodity Futures Contract - [x] Interest Rate Swap - [ ] Real Estate Lease Agreement > **Explanation:** An FRA is most similar to an Interest Rate Swap in that both are used to manage exposure to interest rate movements. Both forms of agreements facilitate the exchange of interest payments based on agreed terms. ### What is the legal requirement for the exchange of principal in an FRA? - [x] There is no exchange of principal - [ ] Mandatory exchange of principal - [ ] Exchange of principal upon mutual agreement - [ ] Conditional exchange based on market trends > **Explanation:** In an FRA, there is no actual exchange of principal. The agreement focuses solely on the exchange of interest payments corresponding to the net difference between the agreed rate and the market rate. ### Can an FRA be used for speculative purposes? - [x] Yes, it can be used for speculation - [ ] No, it is solely for hedging - [ ] Only under regulatory approval - [ ] Speculation is legally forbidden > **Explanation:** While primarily used for hedging purposes, FRAs can also be used by traders and investors to speculate on future interest rate movements, potentially achieving gains from the predicted rate changes.

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