FRAs

FRAs, or forward rate agreements, are over-the-counter financial derivatives used to hedge or speculate on future short-term interest rates. A typical FRA contract lets two parties lock in a fixed rate for a stated borrowing or lending period beginning at a future start date. The contract specifies a notional amount, a start date and end date for the forward period, and the fixed rate. At the settlement date, usually the start date, the parties exchange a cash amount determined by the difference between the observed reference rate for the period and the fixed rate, adjusted by the period length.

The payoff to the long FRA is N*(R - K)*tau/(1+R*tau), where N is the notional, K is the fixed rate, R is the observed reference rate for the period, and tau is the year fraction of the period. If R exceeds K, the long holder receives a payment; if R is below K, the short holder pays. No principal is exchanged; only the cash settlement reflects the rate difference.

FRAs are typically traded over the counter and are cash-settled. They enable market participants to hedge interest rate risk for a specific future window or to speculate on rate movements without lending or borrowing the full notional amount. They are distinct from exchange-traded interest rate futures in being non-standardized and involving bilateral credit risk, though some markets have moved toward central clearing or standardized conventions for certain FRAs.

Notational forms such as 3x6 FRA indicate a contract where the forward period starts in three months and lasts for three months. In finance, FRAs are primarily forward-looking tools tied to short-term interest rates; other uses of the acronym exist in different fields.