Finance term
Forward Rate Agreement (FRA)
Also known as: FRA, forward rate agreement, interest rate forward
Definition
A Forward Rate Agreement (FRA) is an over-the-counter derivatives contract that locks in an interest rate for a future period on a notional principal amount — allowing a borrower or lender to hedge against rate movements before a loan is drawn or refinanced. Settlement is cash-based on the difference between the agreed rate and the prevailing market rate at settlement.
Detailed explanation
An FRA is a single-period forward contract on an interest rate. The buyer of an FRA locks in a future borrowing rate; the seller locks in a future lending rate. On the settlement date, the net payment is the present value of the difference between the contracted FRA rate and the reference rate (historically LIBOR, now SOFR following the benchmark transition mandated by the Federal Reserve at https://www.federalreserve.gov/releases/h15/).
FRA notation: a '3×6 FRA' starts 3 months from today and ends 6 months from today — locking in the 3-month rate that will prevail in 3 months. A '6×12 FRA' locks in the 6-month rate starting 6 months out. This forward-looking structure makes FRAs useful for businesses that know they will borrow in 3-6 months and want to eliminate rate uncertainty.
FRAs are simpler than interest rate swaps — they cover only a single future period rather than a sequence of periods. They are documented under the ISDA Master Agreement or the BBA (British Bankers' Association) standard terms. Settlement occurs at the start of the reference period (discounted back), not at the end. FRA pricing is derived from the yield curve and SOFR futures markets — the same inputs used in swap pricing.
◈ Worked example
- A construction company plans to draw a $2M floating-rate construction loan in 3 months. Enters a 3×9 FRA at 5.50%. If SOFR rises to 6.00% in 3 months, the FRA counterparty pays the difference on the notional — offsetting the higher borrowing cost.
- FRA 3×6 on $5M notional at 5.25%. Settlement date arrives: SOFR 3-month rate = 5.75%. Buyer receives: ($5M × 0.50% × 90/360) / (1 + 5.75% × 90/360) ≈ $6,165 net settlement.
- FRA vs. interest rate cap: FRA locks in a rate precisely (no optionality, no premium); cap only pays when rates exceed the strike (optionality has a premium cost). FRA is symmetric; cap is asymmetric.
Common questions
The most-asked questions about Forward Rate Agreement (FRA) — answered straightforwardly.
What is the difference between an FRA and an interest rate swap? +
An FRA covers a single future interest period — one settlement, one payment. An interest rate swap covers multiple sequential periods (typically semi-annual or quarterly for 2-10 years), effectively stacking multiple FRAs into one contract. For short-term rate hedging (one period), FRAs are simpler; for multi-year hedging, swaps are more efficient.
Who uses FRAs? +
Banks use FRAs to hedge their balance-sheet rate exposure on short-term assets and liabilities. Corporate treasurers use them to lock in rates on planned short-term borrowings. Brokers use FRA markets to express short-term rate views. For most SMBs, the practical equivalent is requesting a rate lock from a lender for a future commitment — the lender absorbs the FRA cost in their pricing.
What replaced LIBOR as the reference rate for FRAs? +
SOFR (Secured Overnight Financing Rate) is the primary replacement in the US, as mandated by the Federal Reserve and Alternative Reference Rates Committee (ARRC). SOFR-based term rates (published by CME) are now the standard reference for FRAs, interest rate swaps, and floating-rate loans in the US. The LIBOR transition was largely completed by mid-2023.
Further reading
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https://clearvaluelending.com/glossary/forward-rate-agreement