What it means
An FRA is best understood as an insurance policy on an interest rate rather than as a loan. One side agrees to pay a fixed rate and receive the floating market rate, and the other side does the reverse, on an agreed notional amount for an agreed future period.
The naming convention looks cryptic but is simple once explained. A 3x6 FRA covers a three-month period that begins three months from today and ends six months from today, while a 6x12 FRA covers the six-month period starting half a year out.
The notional amount is never exchanged, which is what makes FRAs efficient. Only the interest difference changes hands, and it is settled at the start of the interest period rather than at the end, so it is discounted back to reflect the earlier payment date.
Companies reach for FRAs when a borrowing is planned but not yet drawn. A business that has agreed a floating rate facility it will draw in three months can fix its rate now, so a rate rise between the signing and the drawdown does not derail the project economics.
The main nuance is that an FRA hedges the rate, not the loan. If the borrowing is delayed, cancelled or drawn at a different amount, the company is left with a standalone position that will still settle, which is why FRA notional amounts and dates should be reviewed whenever a funding plan changes.
In practice
Real-world examples.
Example
A property developer has committed to a construction facility that will be drawn in six months at a floating rate. It buys a 6x12 FRA on the expected balance so that a rate rise before drawdown cannot push the project past its approved funding budget.
Example
A corporate treasury expecting a large tax refund in four months sells an FRA to fix the rate at which it will place the cash on deposit. When short-term rates subsequently fall, the FRA settlement makes up the shortfall in deposit interest.
Example
A mid-sized retailer with a rolling working capital facility repriced every three months uses a strip of FRAs to fix its rate for the next four repricing dates. The finance director can then present a single interest cost line in the annual budget rather than a range.
Formula
Calculation
Settlement amount = notional x (reference rate - contract rate) x (days / 360), divided by (1 + reference rate x days / 360).
A company expects to draw $20,000,000 for 90 days starting in three months, and buys a 3x6 FRA at a contract rate of 4.00% to protect against rate rises. At settlement, the 90-day market reference rate has risen to 5.00%.
Rate difference = 5.00% - 4.00% = 1.00%.
Raw interest difference = $20,000,000 x 1.00% x 90 / 360 = $50,000.
Discount factor = 1 + (5.00% x 90 / 360) = 1.0125.
Settlement paid to the company = $50,000 / 1.0125 = $49,382.72.
The company receives $49,382.72 at the start of the period. It then pays the higher market rate on its actual loan, and the settlement offsets the extra interest almost exactly, leaving it near its intended 4.00% cost.Case study
Seen in the real world.
What follows is an illustrative example built around a fictional company. Ashfield Cold Storage, an invented logistics operator, won a contract that required a new freezer facility with a $20,000,000 floating rate loan due to be drawn four months after board approval. The business case worked at an interest cost of about 4%, and the board asked what would happen if rates moved before the money was drawn.
The treasurer bought a 3x6 FRA at 4.00% covering the first 90-day interest period, then a second FRA covering the following quarter. When the reference rate reached 5.00% at the first settlement date, the FRA paid Ashfield just under $50,000, which offset almost all of the extra interest on the drawn loan.
The illustrative lesson was less about the money than about the discipline. Because the FRA dates had been matched to the drawdown schedule, the hedge behaved as intended, and the fictional operator's board approved a standing policy of fixing the first year of interest cost on any new capital project.
Watch out
Common mistakes.
- Believing the notional amount is borrowed or lent, when only the net interest difference is ever settled.
- Forgetting that FRA settlement is discounted because it is paid at the start of the period rather than the end, which makes hand calculations come out slightly too high.
- Leaving an FRA in place after the underlying borrowing has been cancelled, which turns a hedge into an open interest rate bet.
Questions
People also ask.
What does 3x6 mean in an FRA quote?
It means the interest period starts three months from today and ends six months from today, so the period covered is three months long.
Is an FRA the same as an interest rate swap?
No, an FRA covers a single future interest period, while a swap covers a series of them and can run for many years.
Who takes the other side of an FRA?
Usually a bank, which either finds an offsetting client position or hedges the exposure in the wider interest rate market.
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