What is a Forward Rate Agreement (FRA) and how does settlement work?

A Forward Rate Agreement (FRA) is a contract where two parties agree to lock in an interest rate for a future period. No loan actually changes hands — it's a pure bet on where interest rates will be.

Key terminology:

• FRA notation: An "A × B" FRA means the contract settles in A months and the underlying loan period ends in B months
• Example: A 3×6 FRA settles in 3 months, based on the 3-month rate starting in 3 months (i.e., months 3 through 6)

How it works:

1. Two parties agree on a fixed rate (the FRA rate) today
2. At settlement (time A), the FRA rate is compared to the actual market rate (the reference rate)
3. The difference determines who pays whom

Settlement formula:

Payment = Notional × (Reference rate - FRA rate) × (Days/360) / [1 + Reference rate × (Days/360)]

The denominator discounts the payment because settlement occurs at the beginning of the loan period, not the end.

Worked example:

DeltaWave Corp enters a 3×9 FRA (6-month loan starting in 3 months) as the fixed-rate payer (long position):

• Notional: $10,000,000
• FRA rate: 4.50%
• At settlement, the 6-month reference rate is 5.20%
• Days in period: 180

Calculation:

Payment = $10,000,000 × (0.052 - 0.045) × (180/360) / [1 + 0.052 × (180/360)]

Payment = $10,000,000 × 0.007 × 0.5 / [1 + 0.026]

Payment = $35,000 / 1.026

Payment = $34,113

Since the reference rate (5.20%) exceeded the FRA rate (4.50%), the long position (DeltaWave) receives $34,113. This compensates DeltaWave for the higher borrowing cost.

Who uses FRAs?

• A company expecting to borrow in the future locks in today's forward rate
• If rates rise, the FRA payment offsets the higher borrowing cost
• If rates fall, the company pays on the FRA but benefits from cheaper borrowing

Exam tip: Remember that FRA settlement is discounted (paid upfront) rather than paid at the end of the loan period. This is the most commonly tested nuance.

Practice FRA calculations in our CFA Level I question bank.