A forward rate agreement (FRA) is a financial contract between two parties that allows them to lock in a specific interest rate for a future period of time. This type of agreement is commonly used by banks, financial institutions, and large corporations to hedge against fluctuations in interest rates.
The International Swaps and Derivatives Association (ISDA) is a global trade organization that represents participants in the derivatives markets. ISDA has developed a standard set of documentation for FRAs, which is widely used in the industry.
The ISDA FRA documentation includes a Master Agreement, which outlines the general terms and conditions of the FRA, as well as a Schedule, which defines the specific terms of each individual FRA. The Schedule includes details such as the start and end dates of the FRA, the notional amount of the agreement, and the fixed interest rate to be paid by one party to the other.
One key feature of an FRA is that it is settled in cash, rather than through the exchange of physical assets. This means that the parties involved in the FRA do not actually exchange the underlying assets that the FRA is based on, which is typically a reference interest rate such as LIBOR (London Interbank Offered Rate).
Instead, the parties settle the FRA based on the difference between the fixed interest rate agreed upon in the FRA and the prevailing market interest rate at the time of settlement. If the prevailing market interest rate is higher than the fixed rate agreed upon in the FRA, the party that sold the FRA (i.e. agreed to pay the fixed rate) will make a payment to the other party. If the market interest rate is lower than the fixed rate, the party that bought the FRA (i.e. agreed to receive the fixed rate) will make a payment to the other party.
Overall, an FRA can be a useful tool for managing interest rate risk in the financial markets. The standard documentation provided by ISDA helps to ensure consistency and clarity in the terms of these agreements, which can help to reduce the risk of disputes or misunderstandings between counterparties.