A Forward Rate Agreement (FRA) is a financial contract between two parties to exchange interest payments on a `notional principal’ amount on a pre-determined settlement date, for the duration of the contract.
In conventional forward rate agreements, two parties swap a fixed interest rate for a variable one. The borrower is the party responsible for paying the fixed rate, while the lender is the person responsible for paying the variable rate.
Forward rate agreements are net-settled and do not involve the actual transfer of the notional principal amount.
On the contract settlement date, if the variable reference interest rate (as defined in the contract) is higher than the fixed interest rate, the lender pays the borrower, the differential interest rate (variable rate less fixed rate) computed on the notional principal amount for the duration of the contract.
The reverse happens when the variable rate on the settlement date is lower than the fixed contractual rate. In this case the borrower pays to the seller the the differential interest rate (fixed rated less the variable rate) computed on the notional principal amount for the duration of the contract.
Forward rate agreements help borrowers hedge against interest rate risk on their borrowings by effectively converting their borrowings from a floating rate to a fixed rate structure by locking in the interest rate payable.