Forward Rate Agreement (FRA)
A Forward Rate Agreement (FRA) is an over-the-counter contract that locks in an interest rate for a future borrowing or lending period. The buyer pays the fixed FRA rate and receives the prevailing market rate. Settlement is in cash at the start of the reference period, with the interest differential discounted back to the settlement date because the cash flow comes earlier than the natural end-of-period payment (Hull, 2022, §4.7).
Why it matters
An FRA is a handshake bet on a future rate. Two parties agree today on what an interest rate will be over some future period. On the fixing date, they compare the agreed rate with the actual market rate and exchange the difference in cash. The naming convention is starts-by-ends, so a $3 \times 6$ FRA starts in 3 months and ends in 6 months, covering a 3-month period. Banks use FRAs to manage funding gaps and to take views on the path of central bank policy.
Formulas
Worked examples
A corporate buys a $3 \times 6$ FRA on A$10 million at 5.00%. Three months later, 90-day BBSW fixes at 5.50%.
Numerator . Denominator . Settlement = 12{,}328.77 / 1.01356 \approx \text{A}\12{,}163$ received by the buyer at the start of the borrowing period. The discounting reflects that the payment lands three months earlier than the equivalent interest differential would on a real loan.
An Australian super fund is worried that the RBA will keep rates higher for longer and wants to lock in 90-day funding for an issuance in 6 months.
The fund buys a $6 \times 9$ FRA at the bank's quoted rate. If 3-month BBSW fixes above that rate at month 6, the buyer receives a discounted cash settlement. The hedge is independent of whether the fund actually issues paper, so it provides clean rate insurance without locking in a specific lender.
Common mistakes
- ✗FRA settlement happens at the end of the reference period. No, it is paid at the start and discounted back. This timing convention is the reason for the factor.
- ✗A $3 \times 6$ FRA covers 3 to 6 years. It covers months 3 to 6. The notation is starts-by-ends in months, so the reference period is 3 months long, starting 3 months from today.
- ✗FRAs eliminate all risk for the buyer. They eliminate rate uncertainty, but counterparty credit risk remains because FRAs are over-the-counter. Standard practice now collateralises FRAs under an ISDA Credit Support Annex.
Revision bullets
- •OTC, cash-settled rate contract
- •Locks in a future interest rate
- •Settles at the start of the period, discounted
- • notation, starts at month , ends at month
- •Used by banks and corporates to manage rate exposure
- •Carries counterparty risk, usually collateralised
Quick check
An FRA is settled
A $3 \times 9$ FRA refers to a contract that
Connected topics
In learning paths
Sources
- Hull (2022), §4.7Hull, John C. Options, Futures, and Other Derivatives. 11th ed. Pearson, 2022. ISBN 978-0-13-693997-9.Standard textbook derivation of FRA pricing and settlement, including the discount factor for early payment.
- Bank for International Settlements. "OTC derivatives statistics, semi-annual survey." BIS Statistical Release, 2025.Source for the size of the global FRA market, part of the broader OTC interest rate derivatives sector.
- International Swaps and Derivatives Association. "2002 ISDA Master Agreement." ISDA, 2002.Standard documentation framework for OTC FRAs, including netting and credit support provisions used to mitigate counterparty risk.