Rates Equities and Portfolio Forwards · Forwards Trading Guide

A forward rate agreement manages a future interest period without lending the notional principal. The reference rate and settlement convention determine the cash flow.

Identify the future interval

A traditional FRA specifies a notional amount, a fixed rate and a future borrowing or lending period. A payer of the fixed rate benefits when the agreed floating reference rises above it. The notional is used to calculate the interest difference and is not normally exchanged. The actual loan remains a separate contract with its own credit spread and funding requirements.

Calculate an advance settlement

Consider a hypothetical traditional FRA on $1 million for a future three month interval. The fixed rate is 4%, the observed reference is 5%, and the accrual fraction is 0.25. The interest difference at the period’s end is $2,500. If the contract settles at the start using discounting at the observed reference, the payer of fixed receives $2,500 ÷ 1.0125, approximately $2,469.14.

Keep the benchmark consistent

This calculation describes a specified term rate and advance settlement convention. A contract referencing compounded overnight rates may observe rates across the period and use different timing or formulas. Do not insert a SOFR observation into an old term rate worksheet without checking the agreement. Day count, fixing time, payment adjustment and fallback provisions must all match.

Assess the underlying hedge

If the real loan costs the reference plus a changing lender spread, the FRA does not automatically fix that spread. A different reset date or loan amount also creates a mismatch. Compare the combined loan and derivative cash flows, including when the settlement is received. A lower future reference produces a payment by the fixed payer even though the underlying loan may become cheaper.

Try it yourself

Using the same advance settlement convention, notional is $2 million, the fixed rate is 3%, the observed rate is 2% and the accrual fraction is 0.25. What does the fixed payer owe?

Show the worked answer

Approximately $4,975.12, calculated as $2 million × 0.01 × 0.25 ÷ 1.005. This offsets part of the benefit of lower reference borrowing costs.

Further reading

Educational material. Numerical examples are hypothetical and exclude costs unless stated. Forward contracts create binding obligations and may require collateral or credit approval. Actual terms, access and risks depend on the agreement and jurisdiction.

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