Forward Rate Agreement

A forward rate agreement(FRA) is a contract between two parties to exchange interest (coupon) payments on a specified notional principal amount for one future period of predetermined length (i.e., one month forward for three months). Only interest flows are exchanged and no principal is exchanged. In a generic FRA one party pays fixed and the other party pays floating. This exchange allows for conversion of variable rate funding to fixed rate exposure or fixed rate funding to variable rate exposure. An FRA is essentially a short-term, single period interest rate swap.
Settlement of an FRA is on a net basis and can occur on the start date or the maturity date. If the FRA is settled on the start date, the settlement is on a present value basis. If the FRA is settled on the maturity date, the settlement is on a same day basis. The settlement reflects the difference between the FRA rate and the floating rate set for the period. The determination of the floating rate depends upon its underlying index (i.e., LIBOR, Commercial Paper, Prime, etc.). For example, LIBOR based swaps are normally discrete setting (LIBOR set at the beginning of the period), while Commercial Paper and Prime swaps are normally averaged (set at the end of the period based on the average of the underlying index during the period).
Normally there is a buyer and a seller of an FRA. The buyer is the fixed rate payer and the seller is the floating rate payer. If interest rates increase, the value of the FRA increases to the buyer. If interest rates decline, the value of the FRA increases to the seller. An FRA can be terminated at any time with the consent of both parties. The termination amount (market value) will depend on relationship between the fixed rate of the FRA and the current market rates. If one party is paying fixed and interest rates decline, that party will most likely have to pay to terminate the FRA. Conversely, if one party is paying fixed and interest rates rise, that party receives the added value upon termination.
Parties to an FRA take on potential credit exposure to one another. At BNY formal credit approval is required before entering into an FRA with a counterparty.
EXAMPLES OF PAYMENT FLOWS If fixed rate = floating rate, there is no FRA payment If fixed rate > floating rate, the fixed rate payer pays the net amount If fixed rate < floating rate, the floating rate payer pays the net amount:
TYPICAL CHARACTERISTICS

Start date: Forward
Term: 1 period (usually a month, quarter, half year or full year)
Day Count: 30/360, Actual/360, or Actual/365

Structure: Bullet, Amortizing, Accreting, or Zero-Coupon
Floating Rate Index: LIBOR, Prime, Commercial Paper, T-Bill or other.

TYPICAL FORWARD RATE AGREEMENT APPLICATIONS
Liability Management

Situation 1: A large corporate borrower's debt structure is 50% fixed and 50% floating. Their treasury department foresees interest rates rising at the end of the year and the corporation wants to fix more of its debt during that period.
Solution: The corporation could pay off some of its floating rate debt and issue or borrow additional fixed rate debt. However, this process could be onerous and the transaction costs could be high. An easier and less costly process is to enter into an FRA. The FRA converts the borrower’s floating rate exposure (LIBOR, Prime, Commercial Paper, T-Bill) to a fixed rate for the final quarter of the year.
Situation 2: A corporation with seasonal borrowing needs believes that interest rates are going to rise. They realize that they will need to borrow an additional $100 million in the second quarter of the following year.
Solution: The corporation can use an FRA to lock in the rate on the additional borrowing that they will need next year.
Situation 3: Two companies formed a joint venture to build a plant in the last quarter of next year. The plant will be funded by bank debt. Higher interest rates would threaten the project's economics. Construction is scheduled to take 6 months. The borrowings will be paid back in full at the end of construction.
Solution: The joint venture fixes the rate on the bank debt through an FRA. The plant can be built without regard for interest rates and the threat they might have caused.