Forward Rate Agreement

Financial Term – Forward Rate Agreement

A forward contract is an over-the-counter agreement between a buyer and a seller to purchase an asset at a predetermined price at some future point in time.

No money exchanges hands at the outset of such a contract. In place of a buyer paying the price to the short in exchange for delivery, a cash settlement forward contracts nets out the position’s cash value.

A common type of cash settlement forward contract is the interest rate forward contract. The payoff is discounted based on the underlying rate assuming payment at a future point in time. The payoff of such cash settlement interest rate forward agreements, or nondeliverable contracts, is calculated using the forward rate agreement formula.

The general Forward Rate Agreement Payoff formula is calculated as:

FRA = {(Rate at expiration ? Forward contract rate) (Days in underlying rate / 360) 1 + Rate at expiration (Days in underlying rate / 360)

The popularity of Eurodollar time deposits has made FRA’s a commonly used instrument in foreign exchange markets. The London Interbank Offer Rate, or LIBOR, is frequently used as a benchmark rate for such forward contract rates. In general, Eurodollar FRA contracts are based on 30-day LIBOR, 60-day LIBOR, 90-day LIBOR, or 180-day LIBOR.

The typical forward rate agreement is called a plain vanilla contract, exchanging a fixed rate for a variable rate. The standard FRA translates the number of days in the contract to months. For example, a 3 x 6 contract expires in 90 days and is based on 90-day LIBO.

The forward rate market is very large – although not quite as large as the swap market which is a combination of FRAs. Forward contracts can be terminated through cash payment, physical delivery, offsetting position, or default. Because forward contracts are agreements between two private parties, they are subject to substantial default risk.

Financial Terms by BetterTrades