What Is a Forward Rate Agreement?
Forward rate agreement is a contract fixing the interest rate on a notional amount for one specified future period, settled in cash for the difference between the agreed rate and the actual rate. Nothing is borrowed or lent, and settlement happens at the start of the period rather than the end.
A forward rate agreement fixes the interest rate on a single future period. It is the smallest complete unit of the interest rate derivatives market, and everything larger is built from it.
How it works
Two parties agree a rate for a period that has not started yet — for example, three months of interest beginning in six months’ time.
No money is lent. The notional is a calculation base, exactly as in a swap, and it never changes hands.
On the fixing date, the actual rate is observed and one side pays the other the difference between that and the agreed rate, applied to the notional for the period’s length.
The discounting detail
Interest is normally paid at the end of a period. An FRA settles at the beginning of it, so the payment is discounted back to that date.
That is not a technicality anybody can skip. It changes the amount paid, and getting it wrong produces a hedge that does not quite offset what it was meant to.
It exists because it removes credit exposure sooner. Settling at the start means neither party carries an unpaid obligation through the period.
A worked example
A treasurer knows they will borrow 10 million for three months, starting in six months. They want certainty about the rate.
They buy a 6×9 FRA at 4%. The notation means the period starts in 6 months and ends in 9.
Six months later the three-month rate fixes at 5%. The difference is 1% on 10 million for three months — roughly 25,000 — discounted back to the settlement date, so slightly less is actually paid to the treasurer.
They then borrow at the market rate of 5%, and the FRA payment offsets the extra cost. Their net rate is the 4% they fixed.
How it relates to a swap
A swap is a series of these. Each payment period on a vanilla interest rate swap behaves like one FRA, and the swap’s fixed rate is effectively a weighted average of the FRA rates across all the periods.
Which is why the two markets are priced consistently. If the swap rate drifted away from the strip of FRAs, somebody would trade one against the other and take the difference.
And it is why an FRA is used for a single exposure. A treasurer with one borrowing date does not need a multi-year swap; they need one period covered, and a single contract does it more cheaply.
The relationship also makes swaps easier to reason about. A swap is not a mysterious multi-year instrument — it is a sequence of small, individually simple agreements, each about one period, bundled into one document.
The original data
On this site’s thirty-year fee measurement: 5 basis points costs 1.5% of the final balance, 20 costs 5.8%, 75 costs 20.2%, 150 costs 36.5%.
That is the right scale for reading FRA pricing. The bid-offer is quoted in basis points on the rate, and on a large notional over a three-month period those basis points are meaningful absolute sums even though they look negligible written down.
And the round trip cost of 0.0098 on this site’s series — about 2% of the median bar range of 0.493 — is the visible exchange-traded analogue. An FRA’s cost is inside the quoted rate and is not separately visible at all.
What it does not do
It does not provide the money. An FRA fixes a rate; the borrowing still has to be arranged with an actual lender, and a borrower who cannot obtain credit has hedged a loan they cannot get.
It does not cover credit spread. The reference rate is fixed; the margin a lender charges over that rate is not, and a deterioration in the borrower’s standing is entirely unhedged.
And it does not extend past its period. One FRA covers one window, and a rolling exposure needs a series of them or a swap.
That first limitation is the one that catches people out. Rate risk and funding risk feel like the same thing and are not, and the instrument addresses only one of them — which is worth being explicit about, because the scenario where funding disappears is usually the scenario where rates have moved too.
And it does not survive a change of benchmark cleanly. When a reference rate is discontinued, existing contracts have to be transitioned to a replacement, and the replacement rarely has identical credit content — so a hedge written against one benchmark can end up referencing something slightly different through no action of either party.
When it fails
The characteristic failure is hedging the rate and losing the loan. A treasurer fixes their borrowing cost with an FRA, conditions deteriorate, and the bank that was going to lend declines or demands a much wider margin. The FRA still settles — it pays on the reference rate exactly as written — but there is now no borrowing for it to offset, so a hedge has become a standalone position on interest rates. The contract performed correctly against a transaction that never happened.
A second failure is ignoring the discounting. Settlement is at the start of the period, and the un-discounted difference is not the amount paid.
A third is misreading the notation. A 6×9 is a three-month period starting in six months, not a nine-month contract.
A fourth is mismatching the reference rate against what the loan actually charges, which leaves a basis swap exposure behind.
And a fifth is judging it by whether rates moved your way. It was bought for certainty, and that is what it delivered regardless of direction.
Related
Interest rate swap covers what a chain of these becomes. Basis swap covers the exposure left by a reference-rate mismatch. And forward contract covers the same idea applied to an asset rather than a rate.
A forward rate agreement is the single building block that an interest rate swap is made of. Understanding one period properly makes the multi-period instrument obvious, and skipping it is why swaps feel harder than they are.
— Michael Whitman
This page is educational, not financial advice. Test every idea on your own charts before risking money.