The same example holds true for a corporation that plans to issue or roll over commercial paper. In either case, the all-in cost of the CDs is relatively the same. Under the FRA but has a lower cost on its debt. If rates do rise, then the payment received on the FRA should offset the increased interest cost on the CDs. For example, a bank that plans to issue or roll over certificates of deposit, but anticipates that interest rates are headed upward, can lock in today’s rate by purchasing FRA. The payment ends up compensating for any change in interest rates since the contract date.įRA’s are generally used to lock in an interest rate for transactions that will take place in the future. Unlike swaps and caps, where the payment is determined at the outset of each period but settled in arrears, FRA payments are discounted and paid at the beginning of the period. In three months, the payment is determined by comparing the contract rate to current market rates. The buyer receives a payment if market rates exceed the contract rate, but must pay the seller if market rates fall below the contract rate.įor example, hedging a six-month period, that will commence in three months from the contract date, is called a “three against nine” FRA, or 3x9 FRA. One party contracts with another for a fixed rate that applies to a future period. Forward Rate Agreements (FRA’s) are similar to over-the-counter futures contracts (but there is no margin) or single-period swaps.
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