Advantages of a Forward Rate Agreement

Written by natasha gilani
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Advantages of a Forward Rate Agreement
A forward rate agreement is similar in concept to a forward-dated loan. (investment image by Kit Wai Chan from Fotolia.com)

A forward rate agreement (FRA), also called a future rate agreement, is a contract that allows a company to lock an existing interest rate and apply it at a single period in the future. It is a financial instrument that typically “locks” an interest rate on a short-term deposit or loan starting at a date in the future. Two parties, sellers and buyers, draw FRA's such that one party pays a fixed interest rate and receives a floating interest rate, while the other party pays a floating interest rate, and receives a fixed interest rate, on the date of maturity of the agreement. Think of a forward rate agreement as a forward-dated loan.

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Reduction of Exposure to Negative Interest Rates

A forward rate agreement protects a company against the negative consequences of falling interest rates. It allows them to efficiently manage exposure to falling interest rates by safeguarding interest rates on all future investments, including the sale of the FRA. It also allows companies to protect future withdraws against unfavourable, and negative, interest rates. Forward rate agreements are important to companies that deal in high-risk activities, to reduce the negative impact of those risk factors.

Guaranteed Interest Rates

According to Moorad Choudhry in the book “The Bond and Money Markets,” an FRA is an agreement to lend or borrow a notional sum of cash for up to a year, beginning at any point over the next 12 months, at an agreed rate of interest. Forward rate agreements, therefore, are associated with known interest rates. They guarantee an exact interest rate on a deposit or a loan starting on a date in the future. Forward rate agreements are clear and have no associated ambiguities.

According to Brian Coyle in the book "Hedging Interest-Rate Exposures," forward rate agreements are effective in managing interest-rate risks. It protects a company against volatile money markets, which breed variable interest rates.

Flexible

Forward rate agreements are fully customisable, allowing the two parties the flexibility to decide upon a time period and interest rate. Banks typically draw up FRA's based on the unique wants of their customers.

No Principal Requirements

According to Moorad Choudhry, a forward rate agreement has no associated upfront payments or premiums. There is no exchange of principal at the time the agreement is drawn. Forward rate agreements have no transaction fees.

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