A forward rate agreement is a contract, based on a notional principal, between two parties to exchange interest at some defined future date based on the difference between two different benchmark rates. These benchmark rates may be floating, such as an interbank rate, or fixed.
It is easiest to explain most of these derivatives using diagrams. The following example of a 90-day FRA assumes a notional principal of $100m. One part of the agreement is based on payment at a fixed 12% annual rate. The other part is based on LIBOR + 4% (LIBOR is the rate at which credit-worthy banks lend to one another and stands for the London Inter Bank Offer Rate). For our example we will assume LIBOR currently stands at 8%.
Let us assume that on the settlement date LIBOR has risen to 12%. On this day both parties calculate how much each owes the other. The floating rate payer owes the fixed rate payer $4m while the fixed rate payer owes the floating rate payer $3m. These are simply netted and the floating rate payer pays the resulting $1m to the fixed rate payer. If interest rates had fallen the payment would be in the opposite direction.
There is no exchange of principal, a FRA is simply a contractual agreement.
In this example we have used a fixed/floating FRA but the range of possible benchmarks is much wider. A floating/floating FRA could be based on yields at different maturities on the yield curve, 90-day LIBOR rates versus five-year government bond yields for example. FRAs are highly standardized contracts and have been successful for two principal reasons:
Flexibility. Because FRAs represent single netted payment transactions they provide huge flexibility to treasurers.
Comparative advantage. One party may have a relative cost advantage at borrowing floating rate but require fixed rate funding. The other may have the opposite position.