A forward rate agreement, also known as an FRA, is a financial contract between two parties that allows them to lock in an interest rate for a transaction that will occur at a future date. In this article, we will provide an example of how a forward rate agreement works.
Let`s say that Company A is planning to borrow money from Company B six months from now. However, Company A is concerned that interest rates might rise during that time, making the loan more expensive. To mitigate this risk, Company A enters into a forward rate agreement with Company B.
The terms of the agreement are as follows: Company A agrees to pay Company B a fixed interest rate of 3% on a loan of $1 million for a period of six months starting in six months` time. This means that Company A has locked in a borrowing cost of 3% for the loan, regardless of what happens to interest rates in the meantime.
If interest rates do rise during that time, Company A benefits from the FRA because they are paying a fixed rate of 3%. On the other hand, if interest rates fall, Company B benefits because they would be able to earn a higher return on their money elsewhere.
It`s important to note that forward rate agreements are not traded on an exchange, but are instead privately negotiated between two parties. They are often used by companies to hedge against interest rate risk and to ensure that they have a predictable borrowing cost.
In conclusion, forward rate agreements can be a useful tool for companies looking to manage their interest rate risk. By entering into an FRA, they can lock in a borrowing cost for a future transaction, providing them with certainty and predictability.
