A forward rate agreement (FRA) is a contract that allows parties to lock in an interest rate for a future period. The FRA payoff is the financial outcome of this agreement, which is determined by the difference between the agreed-upon rate and the prevailing rate at the settlement date.
In other words, the FRA payoff is the net settlement amount that one party owes the other based on the difference between the fixed rate and the prevailing rate. The party that benefits from the difference is the one who receives payment, and the party that suffers from the difference is the one who makes payment.
The FRA payoff calculation is relatively straightforward. For instance, suppose party A and party B enter into an FRA agreement for a notional amount of $1 million for six months at a fixed rate of 3%. Party A agrees to pay party B based on a prevailing rate of 4%. At the settlement date, the prevailing rate is 5%.
The FRA payoff for party A would be calculated as follows:
FRA payoff = (prevailing rate – fixed rate) x notional amount x (days in the contract/360)
In this example, the FRA payoff for party A would be:
(5% – 3%) x $1 million x (180/360) = $10,000
Therefore, party A would make a payment of $10,000 to party B as the FRA payoff.
The FRA payoff calculation is useful for parties entering into interest rate hedging contracts to minimize their interest rate risk. The FRA payoff is a critical component of the FRA agreement, as it determines the settlement amount that one party owes the other.
In conclusion, the FRA payoff is the net settlement amount in an FRA agreement, determined by the difference between the fixed rate and the prevailing rate at the settlement date. It is a crucial component of interest rate hedging contracts that helps parties minimize their interest rate risk. Understanding FRA payoff calculation is essential for those interested in interest rate hedging and risk management.