Forward Rate Agreement Floating Rate: A Comprehensive Guide
A forward rate agreement (FRA) refers to an over-the-counter (OTC) contract between two parties, where one party agrees to pay a fixed interest rate to the other for a specific period, while the other party agrees to pay a floating interest rate. The FRA is used to hedge against interest rate risks and manage cash flows.
In an FRA, the fixed rate is known as the FRA rate, while the floating rate is the reference rate. The reference rate can be any benchmark rate, such as Libor (London Interbank Offered Rate) or Euribor (Euro Interbank Offered Rate). The FRA rate is determined at the inception of the contract, while the reference rate is determined at the settlement date.
A floating rate refers to an interest rate that changes over time, depending on the underlying benchmark rate. For example, if a borrower has a floating rate loan, the interest rate on the loan will change when the benchmark rate changes. Floating rates are linked to the prevailing market conditions and can be unpredictable.
To manage the interest rate risk associated with floating rates, market participants use FRAs. In an FRA, the party receiving the fixed rate is protected from the risk of rising interest rates, while the party paying the floating rate is protected from falling interest rates. The FRA allows the parties to fix the interest rate for a specific period, ensuring that they know the exact amount of interest they will pay or receive.
The settlement of an FRA occurs at the end of the contract period. At settlement, if the reference rate is higher than the FRA rate, the party receiving the fixed rate pays the difference to the party paying the floating rate. If the reference rate is lower than the FRA rate, the party paying the floating rate pays the difference to the party receiving the fixed rate.
An FRA can be used for a variety of purposes, such as hedging against interest rate risks, managing cash flows, and speculating on interest rate movements. For example, a borrower may use an FRA to hedge against the risk of rising interest rates on a floating rate loan. A company may use an FRA to manage its cash flows by locking in a fixed interest rate for a future period. A speculator may use an FRA to make a profit by betting on interest rate movements.
In conclusion, an FRA floating rate is an OTC contract used to hedge against interest rate risks and manage cash flows. The FRA rate and the reference rate are fixed at the inception of the contract and the settlement date, respectively. An FRA can be used for a variety of purposes, and market participants use it to manage interest rate risks and make profits. With the help of FRAs, market participants can protect themselves from the unpredictability of floating interest rates and ensure that they know the exact amount of interest they will pay or receive.