Legal Definitions - forward-rate agreement

A Forward-Rate Agreement (FRA) is a financial contract between two parties that locks in an interest rate for a future period, starting on a specific date. This agreement allows parties to protect themselves against potential changes in interest rates without actually borrowing or lending the principal amount. Instead, at the future settlement date, one party pays the other the difference between the agreed-upon (forward) interest rate and the actual market interest rate at that time, applied to a notional (imaginary) principal amount.

Here are some examples to illustrate how a Forward-Rate Agreement works:

• Example 1: A Business Hedging Future Borrowing Costs

  Imagine "Tech Innovations Inc." knows it will need to borrow $10 million in six months to fund a new project. The company is concerned that interest rates might rise significantly by then, making their future loan more expensive. To mitigate this risk, Tech Innovations Inc. enters into an FRA with a bank today, agreeing to a specific interest rate for a six-month period starting in six months' time. If, in six months, the actual market interest rate is higher than the rate agreed in the FRA, the bank pays Tech Innovations Inc. the difference. If the market rate is lower, Tech Innovations Inc. pays the bank the difference. This ensures that Tech Innovations Inc. effectively locks in its borrowing cost, regardless of market fluctuations, by receiving or making a payment that offsets the change in the actual loan's interest expense.

• Example 2: A Bank Protecting Future Lending Revenue

  Consider "Global Bank," which has committed to providing a large loan to a corporate client in three months. The bank anticipates that interest rates might fall over the next quarter, which would reduce the profitability of their future loan. To protect its expected revenue, Global Bank enters into an FRA with another financial institution. They agree on an interest rate for a three-month period starting in three months. If, at the settlement date, the actual market interest rate is lower than the FRA rate, the other institution pays Global Bank the difference, compensating for the reduced lending income. Conversely, if rates rise, Global Bank pays the difference, but they have secured their minimum expected return by using the FRA to effectively fix the interest rate for their future lending.

• Example 3: An Investor Securing Future Deposit Returns

  An individual investor, Ms. Chen, expects to receive a substantial inheritance of $500,000 in nine months and plans to deposit it into a high-yield savings account for a year. She is worried that interest rates might decline before she receives the money, reducing her potential investment returns. To lock in a favorable rate, Ms. Chen could enter into an FRA with a financial provider. This agreement would specify an interest rate for a one-year period, beginning nine months from now. If, in nine months, the actual market deposit rate is lower than the rate agreed in the FRA, the provider would pay Ms. Chen the difference, ensuring she receives the desired return. If the market rate is higher, Ms. Chen would pay the difference, but she has secured a floor for her future earnings by effectively locking in the interest rate for her future deposit.