What are Forward Rate Agreements (FRAs)? Explain how FRAs can be used to hedge currency risk.

A forward rate agreement (FRA) is a cash-settled OTC contract between two counterparties, where the buyer is borrowing (and the seller is lending) a notional sum at a fixed ¡nterest rate (the FRA rate) and for a specified period of time starting at an agreed date in the future.

An FRA is basically a forward-starting loan, but without the exchange of the principal. The notional amount is simply used to calculate interest payments. By enabling market participants to trade today at an interest rate that will be effective at some point in the future, FRAs allow them to hedge their interest rate exposure on future engagements.

Concretely, the buyer of the FRA, who locks in a borrowing rate, will be protected against a rise ¡n interest rates and the seller, who obtains a fixed lending rate, will be protected against a fall ¡n interest rates. If the interest rates neither fall nor rise, nobody will benefit.

The life of an FRA is composed of two periods of time — the waiting period, or forward, and the contract period. The waiting period is the period up until the start of the notional loan and may last up to 12 rnonttis although durations of up to 6 months are most common. The contract period spans the duration of the notional loan and can also last up to 12 months.

Key dates of a forward rate agreement (FRA) The FRA however effectively ends with the settlement date, as there is no longer any contractual engagement between the two counterparties once the settlement amount has been paid. The contract period ¡s merely one of the calculation parameters used to determine the settlement amount (ERAs are off-balance sheet instruments). FRA terminology

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