Forward Rate Agreements (FRAs)
Lock in today the rate you'll borrow at 6 months from now. If rates rise, the FRA makes up the difference.
Every lesson has an interactive simulation you can drag and play, plus a quick quiz. Sign up free to use them and save your progress automatically. Here is the text version of this lesson.
Not sure yet? Try the first lesson (no sign-up needed)「Interest Rates and Compounding」。
Text version · Interest Rates & Swaps, lesson 2: “Forward Rate Agreements (FRAs)”
Lock in today the rate you'll borrow at 6 months from now. If rates rise, the FRA makes up the difference.
Lock in a future rate now
You only borrow in 6 months, but today you use an FRA to lock the rate at 4%. Whatever the market rate is then, you're covered: the counterparty makes up the difference.
Only the interest difference is settled
The notional principal is only used to calculate interest and is never exchanged. An FRA buyer worries that rates will rise, and if they do, gets compensated: this is a kind of hedge.
What does “6×12” mean?
An FRA is quoted with two month numbers: 6×12 means a six-month rate starting in 6 months and ending in 12 months. The settlement is multiplied by that period (0.5 years), not a full year.
Key takeaways
- An FRA fixes an interest rate for a future period and settles the difference between the market rate and the agreed rate.
- The FRA buyer (worried about rising rates) is compensated when rates rise and pays the difference when rates fall.
- An FRA exchanges only the interest difference, never the principal. "6×12" means it starts in 6 months and ends in 12 months.
- In practice the difference is usually discounted at the market rate back to the start of the interest period and paid then (this lesson skips the discounting to keep things simple).
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- Click “Example: lock 4% · market 5%” and play: on settlement day, who pays whom? What's the “Buyer's settlement”? Why is it 1% × $10 million × 0.5?
- Drag the market rate at maturity to 3%: does the FRA buyer receive or pay money this time?
- Look at the chart below: wherever the market rate lands, does the hedged borrowing cost (cyan line) change?
- Double the notional principal to $20 million: how does the settlement change? Did the notional principal move between the two sides?
Quiz and explanations
- 1. You buy an FRA locking in 4%, and at settlement the market rate is 5%. You will…
- Answer: Receive the difference as compensation.The rate is above the agreed level, so the buyer is compensated.
- 2. What's exchanged when an FRA settles?
- Answer: The interest difference.The notional principal is only used to calculate interest.
- 3. A 6×12 FRA on $10 million notional locks in 4%, and at settlement the market rate is 5.2%. Ignoring discounting, how much does the buyer receive?
- Answer: $60,000.(5.2% − 4%) × $10 million × 0.5 years = $60,000. The interest period is only half a year, so don't forget to multiply by 0.5.
Terms in this lesson
- FRA: A forward rate agreement locks in a borrowing rate for a future period and settles only the rate difference.
- hedge (Hedge): An opposite trade that offsets the risk of an existing exposure.
- notional principal (Notional): The amount used to calculate swap interest; it usually never changes hands.