A forward rate agreement (FRA) is an effective tool to apply a preset interest rate (known as the FRA rate) to a given notional principal amount (NPA) for a certain future period. Suppose a firm is contemplating borrowing $5 million in two months’ time, but is concerned that rates may increase in that period.

The firm needs to hedge itself against such a possibility so it buys a 2×4 FRA at a rate of 5%. This agreement will be in effect two months from the trade date and will expire four months from the trade date (i.e., it has a term of 2 months). If market rates have increased, as expected or feared, the FRA seller will have to pay the firm the difference between the reference rate and the FRA rate). Otherwise, the firm will pay the seller the difference. If the reference rate has ended up at 6%, then the difference is 6%-5%= 1%. The settlement amount is given by:

Settlement = differential × day count basis × NPA

Settlement = 1% × 60 days/ 360 × $5 million

Settlement = 8,333.33

This amount needs to be discounted in order to account for the fact that settlement is usually made at the beginning of the FRA term: The FRA seller pays the firm the discounted value.