Forward Rate Agreement (FRA)
An interest rate forward contract in which the rate to be paid or received on a specific obligation for a set period, beginning in the future, is set at contract initiation. FRAs are settled by net cash payments; that is, the difference between the rate agreed upon and the prevailing market rate at the time of settlement. The FRA buyer receives payment from the seller if the prevailing rate exceeds the rate agreed upon, and vice versa.
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.