Forward Rate Agreement Formula

FRA Settlement Formula:

\[ \text{Settlement} = \frac{\text{Notional} \times (r_{\text{market}} - r_{\text{contract}}) \times t}{1 + r_{\text{market}} \times t} \]

Notional Amount:

currency

Market Rate (r_market):

decimal

Contract Rate (r_contract):

decimal

Time Period (t):

years

Settlement Amount: currency

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1. What is a Forward Rate Agreement (FRA)?

Definition: An FRA is a financial contract that determines the interest rate to be paid or received on an obligation beginning at a future start date.

Purpose: FRAs are used to hedge against future interest rate exposure or to speculate on future interest rate movements.

2. How Does the FRA Settlement Formula Work?

The calculator uses the formula:

\[ \text{Settlement} = \frac{\text{Notional} \times (r_{\text{market}} - r_{\text{contract}}) \times t}{1 + r_{\text{market}} \times t} \]

Where:

\( \text{Settlement} \) — Cash settlement amount (currency)
\( \text{Notional} \) — Notional principal amount (currency)
\( r_{\text{market}} \) — Market reference rate (decimal)
\( r_{\text{contract}} \) — Agreed contract rate (decimal)
\( t \) — Time period in years

Explanation: The formula calculates the present value of the interest rate differential between the market rate and the contract rate.

3. Importance of FRA Settlement Calculation

Details: Accurate settlement calculation ensures proper valuation of the contract and correct payment between counterparties.

4. Using the Calculator

Tips: Enter the notional amount, market rate, contract rate (as decimals, e.g., 0.05 for 5%), and time period in years.

5. Frequently Asked Questions (FAQ)

Q1: What's the difference between r_market and r_contract?
A: r_market is the prevailing interest rate at settlement, while r_contract is the rate agreed upon when the FRA was initiated.

Q2: How do I convert percentage rates to decimals?
A: Divide the percentage by 100 (e.g., 5% = 0.05).

Q3: What time period should I use for t?
A: Use the actual time period of the FRA in years (e.g., 3 months = 0.25, 6 months = 0.5).

Q4: What does a negative settlement mean?
A: A negative result means the buyer pays the seller; positive means the seller pays the buyer.

Q5: Is notional amount exchanged?
A: No, only the interest differential is settled, not the principal.