Forward rate agreement
(FRA).
1.
A short term interest rate derivative.
It is a contract for differences, settled on a single fixed date by reference to an agreed market reference rate.
FRAs are used by corporates to hedge or transform short term interest rate exposures.
For example, an FRA can be used to effectively fix an interest rate for a borrowing to be drawn down at a future date.
2.
More specifically, a bilateral forward contract that fixes the interest rate on the day of the agreement for payment at a future settlement date; this can be up to two years later.
FRAs are used to hedge against interest rate exposure in the sense that one of the parties pays a fixed rate and the other a variable rate.
If, at the settlement date, the market rate if lower than the previously agreed rate, the purchaser will indemnify the seller for that difference and conversely, if the market rate has risen, the seller will compensate the purchaser.
Notation
FRA rates are denoted in a number of different conventional ways.
For example, '2 X 5', '2 v 5' and '2-5' all refer to the maturity two to five months.
That is, the rate for the three-month period, which starts in two months' time.
