Forward rate agreement (FRA) and swap are two common financial instruments that are used by various businesses and investors to hedge against interest rate risks. FRA and swap are similar in many ways, but they differ in several key aspects. One of the main differences between FRA and swap is the way in which they are settled. In this article, we will take a closer look at the forward rate agreement swap difference and explore how these two financial instruments work.
Understanding Forward Rate Agreement
Forward rate agreement is a financial contract that allows two parties to lock in an interest rate for a future period. In an FRA, one party (the buyer) agrees to pay the other party (the seller) a fixed interest rate on a predetermined notional amount for a specific period. The notional amount is the amount of money used to calculate the interest payment, and it is not exchanged between the parties.
The FRA is settled at the end of the predetermined period, and the payment is made based on the difference between the agreed-upon fixed rate and the prevailing market interest rate at the time of settlement. If the market interest rate is higher than the fixed rate agreed upon in the FRA, the seller pays the buyer the difference. If the market interest rate is lower than the fixed rate, the buyer pays the seller the difference.
A swap is also a financial contract that involves the exchange of cash flows between two parties. In a swap, two parties agree to exchange cash flows based on a predetermined notional amount. The cash flows are usually based on interest rates, but they can also be based on other underlying assets, such as currencies or commodities.
In an interest rate swap, one party agrees to pay a fixed rate of interest on a notional amount while the other party agrees to pay a variable interest rate on the same notional amount. The variable interest rate is usually based on a benchmark interest rate, such as the LIBOR rate. The parties exchange cash flows periodically over the life of the swap based on the difference between the fixed rate and the variable rate.
Forward Rate Agreement Swap Difference
The main difference between FRA and swap is the way in which they are settled. In an FRA, the payment is settled at the end of the predetermined period based on the difference between the agreed-upon fixed rate and the prevailing market interest rate. In a swap, the cash flows are exchanged periodically over the life of the contract based on the difference between the fixed and variable interest rates.
Another important difference between FRA and swap is the way in which they are priced. FRA is typically priced based on the prevailing market interest rate for the underlying notional amount and the length of the predetermined period. Swap is priced based on the difference between the fixed and variable interest rates, the length of the contract, and the creditworthiness of the parties involved.
In conclusion, forward rate agreement and swap are two financial instruments that are commonly used by businesses and investors to manage interest rate risks. While they are similar in many ways, they differ in several key aspects, including settlement, pricing, and cash flow exchange. Understanding the forward rate agreement swap difference is crucial for anyone looking to use these financial instruments to manage their interest rate risks effectively.