Forward rate agreements are usually available for borrowings of at least £500,000 in UK.
Forward rate can be agreed with same bank providing the loan or different bank. Issue of loan and forward rate agreement are two separate transactions.
Forward rate agreement is a Hedging product. Forward rate depends on the expected interest rate movement in the market during the period covered by forward rate agreement.
Forward rate agreement usually incurs no or little payment in advance. However, it has cost of Hedging, which is incurred at settlement date. Cost of hedging is embedded in forward rate quoted by the bank. If internet rate is likely to rise during the period covered by forward rate agreement, then forward rate will probably be higher than current interest rate.
Forward rate agreement is the fixing of interest rate on future borrowing or future investment to protect organization from the risk of movement in interest rate until issue date/investment date.
Forward rate agreement is settled on net basis. Cash is transferred to the extent of gain or loss incurred by the organization.
Settlement date is the last date of the contract at which account must be closed. It means gain or loss is decided.
Forward rate agreement is binding (legally enforceable) on the organization. It means organization cannot move back once entered.
FRAs are usually only available for Hedging short-term interest rate risk.
Banks have standard forward rate agreements, which can be used to hedge interest rate risk.
Interest rates are expressed as 12% - 10%. It means forward rate on borrowing is 12% and forward rate on investment is 10%. For hedging borrowing higher rate is applicable and for hedging investment, lower rate is applicable. Difference between investment and borrowing is called spread, which represents profit to the banker.
Duration of FRA is expressed as 7-10 or 7 v 10. It means agreement will start after 7 months and end after further 3 (10-7) months.
Basis point is expressed as 0.01%. It means movement in interest rate is taken into account only when it results in change at least equal to or greater than two decimal places in percentage terms. Movement in interest rate smaller than this amount will not be considered when calculating gain or loss at settlement date.
