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Forward rate agreements (FRAs)

Forward rate agreements (FRAs). Forward rate agreement is a forward contract on interest rates between two parties, typically a bank on one hand and a borrower on the other, with the bank fixing LIBOR for the borrower at an agreed future date.

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Forward rate agreements (FRAs)

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  1. Forward rate agreements (FRAs)

  2. Forward rate agreement is a forward contract on interest rates between two parties, typically a bank on one hand and a borrower on the other, with the bank fixing LIBOR for the borrower at an agreed future date

  3. It is written on a notional principal and cash settled on the basis of the difference between the contract rate and prevailing reference rate on the settlement date. The resultant settlement value is discounted to adjust for an upfront settlement

  4. FRAs are suited to all customers who are exposed to interest rates moving in the short term and wish to cover their exposure

  5. FRAs can be used to lock in a future borrowing or lending requirement (e.g. need to borrow 3 months in 2 months time or have an existing loan rolling over)

  6. Difference between the actual LIBOR prevailing when the future date comes into value and the agreed contract rate are paid on the notional principal. The difference is discounted and paid on the settlement date. It is to be noted that a FRA is not a commitment to enter into a loan or deposit, just a contract for differences

  7. For example, if the agreed six month LIBOR under an FRA is 9 per cent p.a. on a given future date and the actual rate happens to be 10 per cent p.a., the bank will reimburse to the buyer of the FRA the difference of 1 per cent p.a. On the other hand, should the LIBOR happens to be 8 per cent p.a. the borrower will have to pay the difference to the bank

  8. The FRA market has developed from the futures market, but is more flexible in the dates they can provide cover for and there are no margin payments needed.

  9. The customer can use advantageous moves in interest rates to lock in borrowing costs (or return on deposits) prior to the loan or deposit becoming due

  10. As only an interest differential is paid (or received), the underlying loan or deposit does not have to be entered into if cash flow forecasts change.

  11. FRAs are quoted like interest rates, but the terminology used is buy or sell, if a borrower wants to protect against rates moving up he can buy an FRA. A depositor would want to protect against lower rates, so he would sell a FRA

  12. Thank you

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