Forward Rate Agreement
Also written FRA · Forward rate agreements · FRAs · Forward Rate Agreement (FRA)
An OTC contract that locks in an interest rate today for a borrowing or lending period starting later; only the rate difference on a notional principal is settled, in cash.
In plain language
A company knows it will need a loan in three months. It is worried that by then interest rates will have gone up. It cannot take the loan today, but it would like today's rate.
A forward rate agreement gives it that. The company and a counterparty agree a fixed rate now for a borrowing period that begins at a set future date. When that date arrives, they compare the agreed rate with the market reference rate for the period, and one pays the other the difference.
The loan itself is taken separately, at whatever the market rate turns out to be. The FRA's cash settlement tops up or takes away enough that the company's effective cost comes back to the rate it locked in.
How it works
The workbook's description:
- An FRA is an over-the-counter forward contract that enables a borrower (or lender) to lock in an interest rate today for a specified borrowing (or lending) period beginning at a predetermined time in the future.
- FRAs are commonly used to hedge against adverse movements in short-term interest rates.
- The contract is based on a notional principal, used only for calculating the settlement amount and not exchanged between the parties.
The workbook's example. A company plans a six-month loan starting after three months and expects rates to rise. It enters a 3×9 FRA at a fixed rate of, say, 7 percent, against an appropriate market reference rate (the workbook mentions SOFR or other risk-free benchmarks, depending on currency and market practice).
At the start of the loan period the agreed rate is compared with the prevailing reference rate for the six months:
| At settlement | Who pays |
|---|---|
| Reference rate above 7% | The seller of the FRA pays the company the difference — compensating the higher borrowing cost |
| Reference rate below 7% | The company pays the seller the difference |
Settlement is in cash and typically based on the present value of the interest differential.
In the family. FRAs are one of the four interest-rate derivatives the workbook lists, alongside interest-rate futures (exchange-traded, underlying a debt security), interest-rate swaps and interest-rate options (caps and floors).
The formula
Interest differential = Notional × (Reference rate − FRA rate) × (days in period ÷ 365)
Settlement amount = Interest differential, discounted to the start of the period
The discounting convention shown in the example below is illustrative; the workbook says only that settlement is typically based on the present value of the differential.
A worked example
Illustrative figures, following the workbook's 3×9 structure. A company buys a 3×9 FRA at 7.00 percent on a notional Rs 100 crore — protection for a six-month borrowing that starts in three months.
Three months later the six-month reference rate is 7.60 percent. Treat the period as half a year.
Differential = Rs 100 crore × (7.60% − 7.00%) × 0.5 = Rs 30.00 lakh
Present value = 30.00 lakh ÷ (1 + 7.60% × 0.5) = 30.00 ÷ 1.038 = Rs 28.90 lakh
The seller pays the company about Rs 28.90 lakh at the start of the period. The company borrows Rs 100 crore in the market at 7.60 percent — Rs 3.80 crore of interest for the half-year — but the FRA payment, grown back to the end of the period, is worth Rs 30 lakh, bringing the net cost back to Rs 3.50 crore, which is 7.00 percent.
If instead the reference rate had fallen to 6.50 percent, the company would pay the seller the present value of Rs 100 crore × 0.50% × 0.5 = Rs 25 lakh — and enjoy a cheaper loan. Either way its cost is fixed at 7 percent. The Rs 100 crore itself never changes hands between the FRA parties.
Why NISM asks about it
Chapter 1.4 (Financial Securities), under interest-rate derivatives. The examinable points are the ones in the workbook's example: OTC, notional principal not exchanged, cash settlement, and which side pays when the reference rate is above or below the agreed rate.
Common exam traps
- The notional principal is never exchanged. It is only the base for calculating the settlement.
- If the reference rate ends above the FRA rate, the seller pays the buyer (the borrower hedging a rise). If it ends below, the buyer pays.
- An FRA is OTC, not exchange-traded — unlike interest-rate futures, which are standardised contracts on an exchange.
- A 3×9 FRA covers a six-month period starting three months from now.
- It hedges short-term interest rates, and it fixes the rate either way — the borrower gives up the benefit of a fall.
- Settlement is in cash, on the present value of the differential, typically at the start of the underlying period.
Where this is taught
- Series IV · Chapter 2: Interest Rate Derivativesintroduced here
- Series III-A · Chapter 1: Introduction to the Financial Systemintroduced here
- Series V-D · Chapter 19: Interest Rate Derivativesintroduced here
- Series III-C · Chapter 1: Introduction to the Financial Systemintroduced here
Related terms
- HedgingTaking a derivative position that moves opposite to an exposure you already have, so gains on one offset losses on the other and the future rate is locked in at a known level.
- Interest-rate derivativesContracts that let borrowers and investors hedge adverse interest-rate movements — interest-rate futures, interest-rate swaps, interest-rate options (caps and floors) and forward rate agreements.
- Interest rate swapAn agreement to exchange streams of interest payments on a notional principal for a set period — typically fixed against floating — where only the net difference ever changes hands.
- Forward rateThe interest rate for a period that starts in the future, implied today by two spot rates — because rolling a short investment must return the same as locking in a long one, or arbitrage follows.
- Interest Rate FuturesA standardised exchange-traded contract to buy or sell a notional government security, or an interest rate itself, at a price agreed today for settlement on a future date.
- Notional principalThe reference amount interest is computed on in a swap, FRA or money market futures contract — it sizes the exposure and the settlement, but it is never exchanged.
- Interest Rate CapA series of interest rate call options, called caplets, that pays the buyer at the end of each period in which the underlying interest rate is above the strike rate agreed in advance.
- Bond forwardAn OTC rupee interest rate derivative in which a buyer agrees to buy a specific Government Security from a seller on a future date at a price fixed today — governed by RBI's Directions of 21 February 2025.