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# Forward Rate Agreement (FRA):

Forward Rate Agreement (FRA) is an Over The Counter (OTC) interest rate derivative contract;  It is an agreement between two parties to exchange fixed to floating or vice versa of interest rate commitment on a notional amount for an agreed period in future. FRA is essentially a forward starting loan but with no exchange of principal amount. The contract terms determine the notional principal amount, fixed interest rate (FRA rate), the reference interest rate, settlement date and maturity date of the notional loan. The principal amount is only notional and never exchanged but only the interest differential i.e., the interest calculated on the difference between the initial FRA rate and the prevailing floating reference rate at the time of settlement is exchanged on the settlement date.

Key concepts in FRA:
Notional Amount: Notional Amount of Loan on which interest is calculated
Buyer of FRA: Borrows notional sum of money - The one who longs the FRA - (typically the one who pays fixed interest)
Seller of FRA:
Lends the notional sum of money - The one who shorts the FRA -(typically the one who pays floating interest)
Reference Rate:  The floating rate used in the FRA contract (LIBOR, EURIBOR etc)
FRA Rate - This is the fixed interest rate the buyer of FRA pays or price of the FRA
Deal Date - Date on which the FRA deal is made
Value Date / Settlement Date - The date on which the forward loan becomes effective - this in fact is the settlement date on which FRA is cash settled with exchange of interest differential
Participants in FRA market: Banks / Corporates
Market: Liquid; quotes are available with banks / dealers across all major currencies

FRA jargon:
Three Sixes (3X6) FRA - means 3 months loan beginning in 3 months time
One Fours (1X4) FRA - means 3 months loan beginning in 1 month
Three Nines (3X9) FRA - means 6 months loan beginning in 3 months

What happens after FRA is contracted:

• If on settlement date, the prevailing market rate of Reference Rate is greater than the contract rate, the seller pays the buyer of the FRA the difference;

• If on settlement date, the prevailing market rate of Reference Rate is less than the contract rate, the buyer pays the seller of the FRA the difference;

• If Reference Rate is same as the FRA rate on settlement date, there is no exchange of cash flows

FRA contract example:

 Buy or Sell Buy Notional Amount 50,000,000 The notional amount for which FRA is contracted Trade Date 15-Mar-07 Date on which FRA is contracted Spot Date 15-Mar-07 Usually 0 to 2 days from Trade Date Value / Settlement Date 15-Jun-07 The date on which the notional loan becomes effective (settlement date); FRA gets cash settled on this date Fixing Date 13-Jun-07 The date on which the Reference Rate is determined- usually 2 days before the Settlement date Maturity Date 15-Dec-07 The date on which the notional loan matures Contract / FRA Rate (%) 4.50 The fixed interest rate at which the FRA is contracted Reference Rate 3M LIBOR The reference rate used for calculation of settlement amount

Settlement of FRA:

As the FRA settlement happens on loan start date (settlement date) i.e., upfront rather than at the end of the contract period (maturity date), the amount of interest differential (between contracted FRA rate and prevailing reference rate on settlement date) is discounted to the settlement date for computing the actual settlement amount; The settlement amount therefore is calculated using the following formula:

Settlement Amount= (SettRate-FRARate)*Principal*Days / (Basis*100+Days*SettRate) where:
SettRate=Settlement Rate (Reference rate prevailing on Rate fixing date)
Basis= Day count basis
(365 or 360)

The above FRA example along with calculation of the settlement amount is demonstrated in this excel spreadsheet.