A forward rate agreement is a contract which is effectively a wager on future interest rates. In a forward rate agreement, each side will agree to pay an amount in the future based on either an agreed fixed rate now or the varying market rate prevailing when the payment is due. In reality, only one payment is made, for whatever the difference between the amounts "owed" are when the agreement is due to be settled.
A forward rate agreement is effectively a deal in which each side agrees to pay a sum representing interest on an imaginary amount of money, known as the principal. It's important to note that this principal never changes hands because there is no loan made. Instead the two sides simply agree to pay the "interest" on a set day in the future. One side agrees to pay a fixed amount worked out on a rate set at the start of the deal, and the other side agreeing to pay a variable amount decided by the actual market rate on the agreed future date.
To give a fictional example of a forward rate agreement, Redbank might agree to pay Blueinsurance a fixed three percent rate on an imaginary $10 million US Dollars (USD) principal in one year's time. Under the agreement, Blueinsurance would therefore owe $300,000 USD on this date. However, Redbank would agree to pay an amount based on the same $10 million USD principal, but using the prevailing market rate in one year's time.
If the prevailing rate at that time was two percent, Redbank would owe $200,000 USD. In this case Blueinsurance would pay the difference between the two sums, which is $100,000 USD. If, however, the prevailing rate was five percent, Redbank would owe $500,000 USD, compared with the $300,000 USD which Blueinsurance owed. Redbank would thus pay Blueinsurance $200,000 USD.
There are two main reasons why an institution would take part in a forward rate agreement. One is purely as a form of speculation or, put another way, as a gamble. The other is as a form of hedging, by which an investor who has money at stake based on a specific event happening will put a slightly smaller amount into an investment or gamble which will pay off if the event doesn't happen, thus minimizing their potential losses, albeit at the price of lower potential gains. In a forward rate agreement, the buyer, which is the side paying the variable rate and thus gambling that it will fall, may be hedging against other investments which rely on interest rates rising. The seller, which is the side paying the fixed rate and thus gambling that the variable rate will rise, may be hedging against other investments which rely on interest rates falling.
