Forward Rate Agreement Convention

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A forward rate agreement, or FRA, is a financial contract between two parties that agrees to set a fixed interest rate for a future period of time. In order to avoid future uncertainty about the interest rate, parties enter into an FRA contract to eliminate the risk of fluctuating interest rates. The FRA convention, on the other hand, is the set of rules and practices that govern the calculation and settlement of these agreements.

The FRA convention uses a simple formula to calculate the settlement amount, or the difference between the agreed-upon interest rate and the market rate at the time of settlement. The settlement amount is calculated by multiplying the notional amount, or the amount being borrowed or lent, by the difference between the agreed-upon rate and the market rate.

The agreed-upon interest rate, also known as the forward rate, is typically derived from the prevailing market rates at the time the FRA is entered into. This rate is fixed for a specific period of time, usually between three and 12 months. The market rate, on the other hand, is the prevailing interest rate at the time of settlement.

The FRA convention also requires parties to settle the contract on a predetermined settlement date. Settlement dates are typically set for a specific point in the future, such as one or two months after the FRA agreement is signed. When the settlement date arrives, the parties exchange the settlement amount, which is determined by the formula mentioned earlier.

The FRA convention also provides for the possibility of canceling or offsetting FRAs. Canceling a contract involves voiding the original FRA agreement, while offsetting involves entering into a new FRA with terms that mirror the original contract. These options exist to allow parties to adjust their positions if market conditions change or if they need to exit the contract for other reasons.

In conclusion, the FRA convention is a set of rules and practices that govern the calculation and settlement of forward rate agreements. This convention ensures that parties have a clear understanding of the terms and conditions of the FRA agreement, reduces the risk of market volatility, and allows for flexibility in the event that either party needs to adjust their position. By following the FRA convention, parties can enter into FRA contracts with confidence and certainty about the future interest rate.

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