Forward Rate Agreement Example Pdf
Forward rate agreements (FRAs) are a popular financial instrument used by businesses and investors to manage their interest rate risk. Essentially, an FRA is a contract between two parties where they agree to exchange a fixed interest rate for a floating interest rate on a predetermined future date.
To help understand how FRAs work, it can be helpful to look at an example. Let`s say that a business is concerned about the possibility of interest rates rising in the future, which would make it more expensive for them to borrow money. They decide to enter into an FRA with a bank to “lock in” a fixed interest rate for a future loan.
The FRA contract might state that the business will pay the bank a fixed rate of 3% on a $100,000 loan that will be taken out in three months` time. If, at that time, the prevailing interest rate is higher than 3% (the “strike rate” of the FRA), the bank will pay the business the difference between the fixed rate and the actual rate. If the prevailing interest rate is lower than 3%, the business will pay the bank the difference instead.
Here`s a simplified example of how this might play out:
– Business and bank agree to an FRA with a strike rate of 3% and a notional amount of $100,000.
– Three months later, when the loan is to be taken out, the prevailing interest rate is 4%.
– The business would pay the bank the fixed rate of 3% on the $100,000 loan, as per the FRA contract.
– However, since the actual interest rate is 4%, the bank would pay the business the difference of 1% (or $1,000).
– The business would then take out the loan at the prevailing interest rate of 4%.
This example shows how an FRA can be a useful tool for businesses that want to manage their interest rate risk. By entering into an FRA, they are able to protect themselves against potential rate increases and budget more effectively for their future borrowing costs.
If you`re interested in learning more about FRAs, there are plenty of resources available online, including PDF guides and tutorials. By familiarizing yourself with the ins and outs of this financial instrument, you can better understand how it might be useful for your business or investment portfolio.
