orward Rate Agreements, or FRAs, are a way for a company to lock in an interest ratetoday, for money the

company intends to lend or borrow in the future.

FRAs are cash-settled forward contract on interest rates. This means that no loan is actually extended, even though a
notional principal amount mentioned in the contract. Instead, the borrower (buyer) and the lender (seller) agree to pay
each other the interest difference between the agreed-upon rate (the "Forward Rate") and the actual interest rate on
the future date (the "Floating Rate"). The cash settlement occurs on the day the loan is set to begin.
Many banks and large corporations will use FRAs to hedge future interest rate exposure. The buyer hedges against
the risk of rising interest rates, while the seller hedges against the risk of falling interest rates. Other parties that use
Forward Rate Agreements are speculators purely looking to make bets on future directional changes in interest rates.
An example would help illustrate the point. Suppose the current month is February. Widget Co. needs $5,000,000 in
April which it can repay back in May. In order to hedge against the risk that interest rates may be higher in April than it
is in February, the company enters into an FRA with Bank Z at 6% FRA rate. In this case it would be a 2X3 FRA,
meaning a 1 month loan to begin in 2 months, with a notional principal of $5,000,000. In April, if the interest rate rises
to 8%, Bank Z would pay Widget Co the increased interest arising from the higher rate. If on the other hand interest
rate falls to 4%, Widget Co would pay Bank Z.
FRAs trade over the counter (OTC), and because they are not exchange traded, both the notional amount of the loan
and the FRA rate can be negotiated and customized. Also, since the contract is cash settled, no loan is actually given
or received, but rather the contracts are settled on the first day of the underlying loan.

FRA Terminology
The fixed rate, also called the FRA rate, is negotiated and agreed upon by both parties before the contract is entered
into. The floating rate, also known as the reference rate, is an interest rate that will fluctuate between when the
contract is agreed upon, and when the loan is set to begin. The two most common floating rates used in FRAs
are LIBOR andEuribor.
FRAs are quoted in the format AxB, with (A) representing the number of months until the loan is set to begin, and (B)
representing the number of months until the loan ends. To find the length of the loan, subtract A from B. For example,
1x4 quote would mean a 3 month loan, set to begin 1 month in the future. Common formats for these quotes include
1x4, 1x7, 3x6, 3x9, 6x9 and 6x12.

How do Forward Rate Agreements Work?

The mechanics and uses to using FRAs are best shown through an example. Throughout this example 3 months is
equated to 90 days.

Mechanics of a FRA
Consider Company Z on March 1, 2009, which due to unforeseen circumstances must now find $10 million for an
expenditure to occur on June 1, 2009. Company Z expects to generate revenue, and the company expects to be able
to repay this amount on September 1, 2009. Company Z has a number of ways to meet this expenditure; in this
example we only compare a traditional loan to an FRA.
Let's assume Company Z can normally borrow funds for 3 months from its local bank at a rate of 3 month Libor plus
100basis points (bps). If the company takes the first alternative, the effective interest rate it would be able to borrow

at would remain unknown until June 1, when it borrows the actual $10 million at 3 month LIBOR plus 100 bps. Note
that this represents a variable interest rate, as the interest rate in 3 months remain unknown until the actual day
arrives. What if the company wishes to know on March 1, 2009 the interest they must pay on the loan, which will not
occur for another 3 months?
Company Z can also get a quote from a FRA dealer (normally a bank). In this example, the company needs a 3x6
FRA quote (with 3x6 meaning a 3 month loan, to begin in 3 months). Let's assume the FRA dealer offers a quote of
7.0%. This means if the 3 month Libor on June 1 is lower than 7.0%, the FRA dealer will earn the difference between
7.0% and the actual interest rate. Intuitively this makes sense, as the FRA dealer is earning 7.0% on this loan, but it
can borrow at the lower 3 month LIBOR rate. However, if on June 1 the rate is higher than 7.0%, it will lose the
difference.
If Company Z accepts the FRA rate of 7.0% on March 1, then 3 months later (June 1), it will settle in cash this
difference between the previously agreed upon 7.0% and 3 month LIBOR on June 1 2009. If the 3 month LIBOR on
June 1 is lower than 7.0%, the company must pay the FRA dealer. However, if it is higher, the company receives
payment from the FRA dealer. Since the company is effectively borrowing at a lower interest rate than otherwise
possible if the 3 month LIBOR is higher than 7.0%, and as such receives payment. To calculate the amount of the
payment, refer to the formula below.