Forward rate agreements (FRAs)

· A forward rate agreement is a forward contact on a short-term interest rate, usually LIBOR.
· It is a forward contract to borrow / lend money at a certain rate at some future date,
· the potential borrower can lock in borrowing rate with FRA, a contract to enter into a loan at a future date.
· Usually settled with cash payment, the amount of settlement makes the total interest rate (actual interest cost + FRA settlement) equal to the contracted interest cost in FRA

If market rate greater than the rate in FRA, bank pay borrower
If market rate smaller than the rate in FRA, borrower pay bank


Settlement
[(notional principal)[(floating rate at settlement – forward rate) (days/360)] / [(1+floating rate at settlement) (days /360)]

Numerator - the difference between the actual rate that exists in the marketplace on the expiration date and the agreed-upon rate at the beginning of the contract.

The divisor - Discounting the payment at the current LIBOR, based on the assumption that they will accrue interest.