Global Markets

Forward Rate Agreement (FRA)

    Using FRA, a company can hedge its interest rate risk arising on account of lending and borrowing made at fixed or variable rates. There is no actual exchange of principal amount and the interest payments are calculated only on notional principal amounts.
     
    In an FRA, the company enters into a contract with the bank for exchanging interest payments for a notional principal amount on the settlement date for a specified period from start date to maturity date.
     
    Accordingly, on settlement date, the cash payments between the company and the bank are exchanged, based on the difference between the contracted rate and the settlement rate. The settlement rate is the agreed benchmark or reference rate such as Mibor prevailing on the settlement date.

    FRA thus enables a party a guaranteed future rate of interest for a specified period of time on a notional principal (loan /deposit) in the future.

Terminology

    • Deal date: Date when the transaction is initiated.
    • Fixing date:Date when the reference rate of FRA is fixed. It is generally two days prior to the settlement date.
    • Settlement date:Date when the settlement sum is paid.
    • Contract Period:Period from Settlement date to the Maturity date.
    • Maturity date:Date when the contract ends.
    • Settlement sum:The amount exchanged between counterparties as per the terms of the FRA (i.e. the difference between contracted & settlement rate).

Quotation

    • An FRA for a 3-month period commencing in 3 month’s time from spot date is quoted as a “3x6 FRA”.
    • An FRA for a 6-month period commencing in 6 month’s time from spot date is quoted as a “6x12 FRA”.

Regulations

    While banks and financial institutions are allowed to enter into swaps for hedging their exposures as well as for market making, corporate customers are allowed to enter into FRAs only for the purpose of hedging the interest rate risk on the underlying asset/liability.


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