Forward rate agreement Totally Explained

Everything about Forward Rate Agreement totally explained

In finance, a forward rate agreement (FRA) is a forward contract in which one party pays a fixed interest rate, and receives a floating interest rate equal to a reference rate (the underlying rate). The payments are calculated over a notional amount over a certain period, and netted, for example only the differential is paid. It is paid on the effective date. The reference rate is fixed zero, one or two days before the termination date, dependent on the market convention for the particular currency. FRAs are over-the counter derivatives. A swap is a combination of FRAs. The payer of the fixed interest rate is also known as the borrower or the buyer, whilst the receiver of the fixed interest rate is the lender or the seller.

Payoff formula

The netted payment made at the termination date is:

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The Fixed Rate is the rate at which the contract is agreed.
The Reference Rate is typically Euribor or LIBOR.
$alpha$ is the day count fraction, for example the portion of a year over which the rates are calculated, using the day count convention used in the money markets in the underlying currency. For EUR and USD this is generally the number of days divided by 360, for GBP it's the number of days divided by 365 days.
The Fixed Rate and Reference Rate are rates that should accrue over a period starting on the termination date, and then paid at the end of the period. However, as the payment is already known at the beginning of the period, it's also paid at the beginning. This is why the discount factor is used in the denominator.

FRAs Notation

FRA Descriptive Notation and Interpretation

Notation	Termination date from now	End of period from now	Underlying Rate
1 x 3	1 month	3 months	3-1 = 2 months LIBOR
1 x 7	1 month	7 months	7-1 = 6 months LIBOR
3 x 6	3 months	6 months	6-3 = 3 months LIBOR
3 x 9	3 months	9 months	9-3 = 6 months LIBOR
6 x 12	6 months	12 months	12-6 = 6 months LIBOR
12 x 18	12 months	18 months	18-12 = 6 months LIBOR

Further Information

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