Forward Rate Agreement (FRA) is an agreement between two parties that allows them to lock in an interest rate for future transactions. Typically, the buyer of the FRA will be looking to protect themselves against potential interest rate increases, while the seller is hoping to profit if rates remain stable or decrease. In this article, we will focus on the borrower`s perspective of FRA.
A borrower who is considering taking out a loan with a variable interest rate may use an FRA to hedge against the risk of rising interest rates. The borrower would enter into an agreement with a counterparty to lock in a fixed rate for a specified time period.
For example, let`s say a borrower is considering taking out a $1 million loan with a variable interest rate that is based on the London Interbank Offered Rate (LIBOR). The borrower is concerned about potential interest rate increases over the next six months, which could increase their loan payments. To mitigate this risk, the borrower enters into an FRA agreement with a counterparty to lock in a fixed interest rate for the next six months.
If the LIBOR rate increases over the next six months, the borrower will receive a payment from the counterparty equal to the difference between the fixed rate and the variable rate. This payment can be used to offset the higher interest payments on their loan. On the other hand, if the variable rate stays the same or decreases, the borrower will not receive a payment from the counterparty, but they will still have the peace of mind of knowing their interest rate is fixed.
It`s important to note that an FRA is not a perfect hedge. There are always risks involved, and the FRA may not fully protect the borrower against interest rate increases. However, it can still be a useful tool for borrowers who want to manage their interest rate risk.
In conclusion, an FRA can be a useful tool for borrowers who are considering taking out a loan with a variable interest rate. By entering into an FRA agreement, borrowers can lock in a fixed interest rate for a specified time period and protect themselves against potential interest rate increases. However, it`s important to understand that an FRA is not a perfect hedge and there are always risks involved. If you`re considering using an FRA as part of your borrowing strategy, it`s important to work with a knowledgeable financial advisor who can help you understand the risks and make an informed decision.