Forward Rate Agreement Types: Everything You Need to Know
A forward rate agreement (FRA) is a financial derivative contract that allows two parties to lock in an interest rate for a future date. This type of agreement is commonly used in the financial industry to help mitigate interest rate risk. In this article, we’ll take a closer look at the different types of forward rate agreements available and how they work.
Fixed Rate Forward Rate Agreement
The most common type of FRA is the fixed-rate forward rate agreement. In this agreement, one party agrees to pay a fixed interest rate to the other party at a future date, based on a predetermined notional amount. The other party, on the other hand, agrees to pay the prevailing interest rate at the future date. This type of FRA is typically used by borrowers who want to lock in a fixed interest rate on a loan they plan to take out in the future.
Floating Rate Forward Rate Agreement
The floating-rate forward rate agreement is another type of FRA that is commonly used in the financial industry. In this agreement, one party agrees to pay a floating interest rate to the other party at a future date, based on a predetermined notional amount. The other party, on the other hand, agrees to pay a fixed interest rate at the future date. This type of FRA is typically used by lenders who want to protect themselves against potential interest rate increases.
Interest Rate Swap Forward Rate Agreement
An interest rate swap (IRS) FRA is a type of FRA that is used to protect against interest rate risk in a longer-term deal. In this agreement, the parties exchange cash flows based on different interest rates. One party agrees to pay the other a fixed interest rate based on a predetermined notional amount, while the other party agrees to pay a floating interest rate. This type of FRA is commonly used in the financial industry to hedge interest rate risk in longer-term deals.
Collared Forward Rate Agreement
A collared forward rate agreement is a type of FRA that provides the parties with a range of interest rates. In this agreement, the parties agree to a minimum and maximum interest rate. If the interest rate falls within this range, the parties exchange cash flows based on a floating interest rate. However, if the interest rate falls below the minimum or above the maximum, the parties do not exchange cash flows. This type of FRA is commonly used by borrowers and lenders who want to lock in a minimum and maximum interest rate for a future loan.
Conclusion
Forward rate agreements are a powerful financial tool that allows borrowers and lenders to lock in a future interest rate. By understanding the different FRA types and how they work, you can better protect yourself against interest rate risk and potentially save money. If you are considering using an FRA for your next financial deal, be sure to consult with a financial advisor or professional to determine the best option for your needs.