Example of a Forward Rate Agreement

As financial markets become increasingly complex, financial instruments are also evolving to meet the changing needs of investors. One such instrument is the forward rate agreement (FRA). In this article, we will discuss the features and benefits of a forward rate agreement by providing an example.

What is a Forward Rate Agreement (FRA)?

A forward rate agreement (FRA) is a contract between two parties, where one party agrees to pay a fixed interest rate to the other party at a future agreed-upon date. By using a forward rate agreement, parties fix the interest rate on a future transaction, thereby reducing exposure to interest rate fluctuations.

Example of a Forward Rate Agreement

Let us suppose there are two parties involved in this agreement: Party A and Party B. Party A is a borrower who wants to reduce interest rate risk, while Party B is a lender who wants to earn a fixed interest income.

Party A and Party B agree to enter into a six-month forward rate agreement where Party A will borrow $100,000 from Party B at a fixed interest rate. The agreed-upon interest rate is 5%, and the settlement date is six months from now.

The six-month LIBOR rate is currently 6%. Based on this information, Party A and Party B can calculate the FRA settlement amount.

The fixed interest rate agreed upon is 5%, which is less than the current LIBOR rate of 6%. Therefore, Party A has an incentive to enter into the FRA. If interest rates increase in the future, Party A will still be able to borrow at the fixed 5% rate, which is lower than the market rate, and Party B will earn a fixed income.

Suppose six months from now, the six-month LIBOR rate rises to 7%. In that case, Party A would receive a payment from Party B at the settlement date. The payment would be calculated based on the difference between the fixed FRA rate of 5% and the higher prevailing rate of 7% multiplied by the notional amount ($100,000) and the number of days between the FRA settlement date and the six-month LIBOR rate being reset.

On the other hand, if the six-month LIBOR rate falls below the 5% agreed-upon rate, Party A would have to pay Party B at the settlement date.

Conclusion

In conclusion, forward rate agreements offer a valuable tool for managing interest rate risk by allowing parties to fix a future interest rate. In the example provided above, Party A, a borrower, is protected against rising interest rates, while Party B, the lender, is protected against falling interest rates. The FRA is an important financial instrument for investors looking to mitigate interest rate risk and secure their financial future.

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