Forward Rate Agreements

Imagine a company that knows today it will need to borrow $10 million in three months for a six-month loan, but is worried rates might rise before then. A forward rate agreement, or FRA, lets it lock in today's rate for that future borrowing period without actually exchanging any principal now — it's purely a bet on what the reference interest rate will be over that specific future window.

An FRA is quoted as, say, "3x9," meaning the rate applies to a period starting in three months and ending in nine months (a six-month period). At the start of that period, the contract settles in cash: whoever agreed to pay the fixed rate pays the difference between that fixed rate and the actual reference rate (like SOFR) observed at settlement, applied to the notional amount and the length of the period, discounted back since the payment happens at the start of the period rather than the end.

As a worked example, on a $10 million notional for a six-month period, if the agreed fixed rate is 4% and the reference rate at settlement turns out to be 4.5%, the borrower who locked in the fixed rate receives roughly $10,000,000 x 0.5% x 0.5 = $25,000 (before discounting), compensating for the higher borrowing cost it will now actually pay in the market.