Forward Rate Agreement (FRA)
A Forward Rate Agreement (FRA) is an OTC rate derivative in which the buyer will pay or receive at maturity the difference between a fixed rate and a reference interest rate applied onto either a borrowing or lending (the notional is never exchanged), for a specific period of time. The contract will determine the rates to be used along with the termination date and notional value. FRAs are used to assist companies in managing their interest rates exposure.
In essence, it is the exchange between buyers that agree to a fixed rate and sellers that agree to floating rates (normally the LIBOR); the buyer wants to protect against rising interest rates but does not want to borrow the money today. Therefore, if the floating rate is higher than the fixed rate agreed at inception, the buyer receives the difference (accounting for the days in the contract) from the seller. The buyer then will enter into a loan contract and the money received from the contract will cover the higher cost of borrowing. If the floating rate is lower than the pre-agreed rate, the buyer will pay the difference to the seller but the cost of borrowing would be lower.