Forward rate agreement (FRA) is a type of financial instrument that is commonly used in the financial markets. It is typically used to manage interest rate risk, which is the risk that arises from changes in interest rates. Forward rate agreement is one of the topics covered in the CFA level 1 curriculum. In this article, we will discuss the key concepts of forward rate agreement and its importance in the financial markets.
What is a Forward Rate Agreement?
Forward rate agreement (FRA) is a contract between two parties to exchange a fixed interest rate for a floating interest rate on a predetermined notional amount of money on a specified future date. In simpler terms, it is an agreement between two parties to lock in a future interest rate. The party receiving the fixed rate payment is said to be the buyer or the borrower while the party receiving the floating rate payment is said to be the seller or the lender.
How does a Forward Rate Agreement work?
In a forward rate agreement, the buyer agrees to pay the seller a fixed interest rate on a notional amount of money for a specified period in the future. In return, the seller agrees to pay the buyer a floating interest rate based on a reference interest rate such as LIBOR (London Interbank Offered Rate).
For example, suppose that a borrower wants to protect himself from an increase in interest rates. He enters into a 6-month FRA agreement with a bank, agreeing to pay 4% fixed rate on a notional amount of $1 million. If the 6-month LIBOR rate at the time of settlement is higher than 4%, the borrower will receive a payment from the bank equal to the difference between the fixed rate and the 6-month LIBOR rate, multiplied by $1 million.
Why are Forward Rate Agreements important?
Forward rate agreements are important in the financial markets for several reasons. Firstly, they allow market participants to hedge or manage their interest rate risk. For example, a borrower can use a FRA to protect himself from an increase in interest rates, while a lender can use a FRA to protect himself from a decrease in interest rates.
Secondly, FRA agreements are often used to speculate on future interest rates. Market participants can take a long or short position on a FRA, depending on their view of future interest rates. For example, if a market participant believes that interest rates will increase in the future, he can take a long position on a FRA to benefit from the increase in interest rates.
Thirdly, FRA agreements are an important tool for central banks to implement their monetary policy. Central banks can use FRA agreements to influence the level of interest rates in the economy. For example, a central bank can enter into a FRA agreement with a bank to provide liquidity to the banking system and influence the level of interest rates.
Conclusion
Forward rate agreements are an important financial instrument that are used to manage interest rate risk, speculate on future interest rates and implement monetary policy. As a CFA level 1 candidate, it is important to understand the key concepts of FRA agreements and their role in the financial markets. By mastering this topic, you will be well-equipped to excel in your career as a finance professional.