A forward rate agreement (FRA) is an agreement between two parties to exchange a fixed interest rate for a predetermined period of time in the future. It is a financial contract commonly used to hedge against the risk of changes in interest rates.
In a FRA, the buyer agrees to pay the seller a fixed interest rate on a specific notional amount of money for a designated time period in the future. In exchange, the seller agrees to pay the buyer the prevailing market interest rate at that time on the same notional amount.
The FRA contract is settled on the settlement date, which is typically the maturity date of the contract. If the prevailing interest rate at that time is higher than the fixed rate agreed upon in the FRA, the seller will pay the buyer the difference. Conversely, if the prevailing rate is lower, the buyer will pay the seller the difference.
FRAs are commonly used by companies, financial institutions, and investors to mitigate the risk of fluctuating interest rates. They allow parties to lock in a fixed interest rate for a future period, reducing uncertainty and exposure to potential losses.
FRAs are typically negotiated in the over-the-counter (OTC) market between two parties, without the intermediation of a formal exchange. As such, they are subject to credit risk, as the performance of the contract is dependent on the financial standing of the parties involved.
In conclusion, a FRA is a financial contract used to hedge against the risk of interest rate fluctuations. It involves an agreement between two parties to exchange a fixed interest rate for a predetermined period in the future. While offering risk mitigation advantages, FRAs are subject to credit risk and are typically negotiated in the OTC market.