A forward rate agreement (FRA) is a forward contract in which one party, the long, agrees to pay a fixed interest payment at a future date and receive an interest payment at a rate to be determined at expiration. It is a forward contract on an interest rate (not on a bond or a loan).

The fixed rate is also called the forward contract rate. The interest rate to be determined at expiration is also called the underlying rate.

The buyer effectively has agreed to borrow an amount of money in the future at the stated forward (contract) rate. The seller has effectively locked in a lending rate. The buyer of a FRA profits from an increase in interest rates. The seller of a FRA profits from a decline in rates.

Example

Shell and Barclays enters into the following FRA:

• Shell, the end user, takes a long position in a FRA that expires in 30 days and is based on 60-day LIBOR.
• Barclays, a dealer, quotes a rate of 5.65% for this FRA.
• The notional principal of this FRA is $1,000,000.

By convention, this FRA is also referred to as a 1 x 3. At the expiration of the FRA in 30 days:

• Shell pays a fixed rate of 5.65% immediately.
• Barclays promises to pay a rate of 60-day LIBOR determined at expiration. Suppose that the 60-day LIBOR at expiration is 6%. Barclays will pay 6% of interest to Shell 60 days after the contract expiration date. In effect, the 6% interest is paid 90 days (30 + 60) from the contract initiation date.