A forward rate agreement (FRA) is a financial contract that allows buyers and sellers to lock in an interest rate at a future date. FRAs are commonly used by banks, financial institutions, and corporate entities to hedge against interest rate fluctuations.

So, how does an FRA work?

In simple terms, an FRA is an agreement between two parties to exchange the difference between a predetermined interest rate and the prevailing market rate. The exchange takes place at a future date, which is also predetermined at the time of the contract.

Let`s take an example. Suppose a bank wants to lend money at a fixed interest rate of 5% for a year, but it is concerned about the possibility of interest rates rising in the future. To hedge against this risk, the bank can enter into an FRA with another party, say a financial institution.

In the FRA agreement, the bank agrees to pay the financial institution the difference between the 5% fixed rate and the prevailing market rate on a notional principal amount (the hypothetical amount on which the interest is calculated) at the future date of the contract. The financial institution, in turn, agrees to pay the bank the same amount if the prevailing market rate is lower than 5%.

Let`s say the notional principal amount in the contract is $1 million, and the future date is one year from now. If the prevailing market rate at that time is 7%, the bank would pay the financial institution $20,000, calculated as follows:

$1 million x (7% – 5%) x (1/360)

On the other hand, if the prevailing market rate is 4%, the financial institution would pay the bank $20,000, calculated as follows:

$1 million x (5% – 4%) x (1/360)

The FRA contract allows the bank to mitigate the risk of interest rate fluctuations and lock in a fixed rate for its loan portfolio. The financial institution, in turn, earns a profit by taking on the risk of interest rate fluctuations.

In conclusion, a forward rate agreement is a financial instrument that allows parties to lock in a fixed interest rate for a future date. It is commonly used by banks and financial institutions to hedge against interest rate fluctuations and is an essential tool in risk management.