Guide

Forward rate agreements explained

Harbor Capital signed a $120M acquisition term sheet with a 90-day close condition. Funding would come from a new three-month revolving draw priced at SOFR + 175 bp, but the deal could slip six weeks while regulators reviewed carve-outs. Treasury did not want to pay swap breakage on a five-year interest rate swap for a bridge that might never fund. Instead they bought a 3×9 FRA — locking a 4.62% all-in borrowing rate on $100M notional for the six-month accrual window starting three months forward. When SOFR spiked 42 bp during the delay, the FRA paid Harbor $1.04M at settlement while the actual loan had not yet drawn. The hedge matched the timing mismatch exactly; a plain swap would have carried basis risk and CSA margin calls on a notional that was still uncertain.

A forward rate agreement (FRA) is an over-the-counter contract between two parties to exchange the difference between a contracted forward rate and the realized floating benchmark over a future accrual period. No principal changes hands at inception or maturity — only a single cash settlement on the rate differential, discounted to the value date. FRAs are the simplest interest-rate derivative: they hedge one future borrowing or lending window without the lifecycle complexity of swaps, options, or futures margin. This guide covers FRA notation and parties, settlement mathematics, SOFR compounding alignment, the Harbor Capital bridge-loan refactor, a technique decision table vs swaps, caps, and money-market alternatives, pitfalls, and a production checklist.

FRA notation and who pays whom

FRAs are quoted with t × T notation: t is months from trade date to the start of the accrual period (settlement date); T is months from trade date to the end of the accrual period. A 3×6 FRA fixes the rate on a three-month loan that begins in three months and ends in six months. A 6×12 FRA covers a six-month accrual starting six months forward.

Borrower vs lender perspective

From a borrower’s view, buying an FRA (entering as the fixed-rate payer) locks a maximum borrowing cost: if realized SOFR exceeds the contracted FRA rate at settlement, the counterparty pays the borrower the difference. From a lender’s view, selling an FRA locks a minimum lending return. The contracted rate is the FRA rate, quoted in percent per annum on the notional for the accrual day-count fraction.

Relation to the forward curve

In frictionless markets, the par FRA rate equals the forward rate implied by today’s yield curve or OIS discount curve. Dealers quote FRAs as a spread over the forward or as an absolute rate. When the curve inverts, short-dated FRAs can trade below spot SOFR even though the borrower still faces rollover risk at the accrual start.

Cash settlement mathematics

FRAs settle once, on the accrual start date (or T+2 business days per convention), in cash. The settlement amount is:

Payment = Notional × (Realized rate − FRA rate) × Day-count fraction × Discount factor

Sign convention: the fixed-rate payer (borrower hedge) receives payment when realized rates rise above the FRA rate. The discount factor adjusts for paying at the start of the accrual period rather than the end — the classic advance settlement convention on sterling and many USD FRAs uses 1 / (1 + realized × τ) where τ is the accrual year fraction.

Day-count and compounding

USD FRAs on SOFR typically use ACT/360 on the accrual period. The realized rate for settlement is the compounded SOFR over the FRA period (or Term SOFR if the loan indexes to term rates). Mismatch between the FRA’s reference index and the actual loan index creates basis risk — the hedge ratio may need a slight notional adjustment or a compounding-aligned FRA template from the dealer.

Worked settlement example

Notional $50M, 3×6 FRA at 4.50%, realized three-month SOFR compounds to 4.92% over the accrual window, ACT/360 with 91 days (τ = 91/360). Undiscounted differential: $50M × (4.92% − 4.50%) × 91/360 = $53,083. After advance discount at 4.92%: roughly $51,450 paid to the fixed-rate payer. No loan principal was ever exchanged; the cash offsets higher interest on the upcoming floating draw.

FRAs in the rates ecosystem

Building blocks for swaps and options

A strip of consecutive FRAs replicates the floating leg of a short-dated swap before convexity adjustments. Swap dealers often hedge new swap books with FRAs and futures on the same forward segments. Caps and floors are portfolios of options on forward rates; understanding FRAs clarifies what caplets are insuring.

FRA vs interest rate futures

Exchange-traded futures (Eurodollar legacy, SOFR futures) standardize contract size, margin, and daily mark-to-market. FRAs are bespoke on notional and dates, better when the loan’s accrual window does not align with IMM quarters. Futures carry convexity bias relative to FRAs when rates are volatile — for large notionals and long accrual gaps, dealers apply a convexity adjustment when converting between them.

Credit and documentation

FRAs trade under ISDA master agreements with CSA collateral schedules like swaps. Because settlement is a single cash flow, exposure peaks around the fixing date rather than accumulating over years. Bilateral credit limits still bind: a regional corporate may face tighter FRA lines than a G-SIB bank.

Harbor Capital bridge-loan refactor (worked example)

Problem: Harbor’s acquisition bridge was uncertain on timing ($0–$120M draw) and duration (3–9 months). A receive-fixed swap on $120M would incur mark-to-market swings and CSA margin while the deal was still pending regulatory approval.

Changes:

Layered three FRAs: 3×6 on $60M, 6×9 on $60M, and 3×9 on $40M as a partial hedge if only two-thirds of the facility drew.
Matched FRA fixing to compounded SOFR in arrears — same convention as the credit agreement’s pricing supplement.
Negotiated advance settlement discounting consistent with the dealer’s swap curve to avoid settlement disputes on the fixing day.
Documented FRA rates in the board risk report as all-in locked funding for scenario analysis alongside unhedged SOFR + 175 bp.
Planned roll: if close slipped past nine months, extend with 9×12 FRAs rather than converting to a swap until draw certainty exceeded 80%.

Result: When SOFR rose 42 bp before close, FRA settlement receipts offset $1.04M of higher projected interest on the eventual draw. Total hedge cost (bid-offer on three FRAs) was 6 bp annualized vs an estimated 18 bp all-in on a prematurely sized swap with breakage risk. Treasury kept flexibility until the loan funded, then replaced FRAs with a plain IRS on the term revolver balance.

Technique decision table

When FRAs fit	Prefer something else
Hedge one known future borrowing/lending window (3–12 months)	Multi-year fixed exposure — plain interest rate swap
Uncertain draw timing; notional may not materialize	Committed long-term debt — swap at issuance
Accrual dates do not match IMM futures quarters	Standardized exchange margin and liquidity — SOFR futures
Cap a single reset on floating-rate paper before roll	Ongoing protection across many resets — cap or collar
Dealer line for quick OTC execution on custom notional	Retail investor — fixed-rate CD or T-bill ladder
Lock forward lending rate on expected bond deployment date	Option on future swap entry — swaption

Common pitfalls

Index mismatch — FRA on Term SOFR vs loan on compounded overnight SOFR produces residual basis at settlement.
Wrong t × T notation — confusing start and end months hedges the wrong accrual window entirely.
Settlement convention drift — advance vs arrears discounting changes cash by tens of basis points of notional.
Notional overshoot — hedging full facility when expected draw is 60% locks negative carry if rates fall.
Ignoring day-count — ACT/360 vs ACT/365 on a 90-day window shifts settlement by ~0.14% of the rate differential.
Credit line expiry — FRA counterparty default on fixing day leaves the borrower unhedged; monitor CSA thresholds.
Convexity when replicating swaps — long FRA strips do not equal a swap without adjustment when the curve moves nonlinearly.
Accounting classification — hedge accounting under ASC 815 requires documentation at inception; retroactive designation fails.
Roll without repricing — letting FRAs expire unrolled into a rising-rate environment removes protection silently.

Production checklist

Confirm loan accrual start, end, and fixing dates match FRA t × T.
Align floating index: compounded SOFR in arrears vs Term SOFR vs legacy.
Verify day-count (ACT/360) and holiday calendar on settlement date.
Agree advance vs arrears settlement discounting with counterparty.
Size notional to expected draw, not maximum facility, unless policy says otherwise.
Obtain par FRA rate from dealer and compare to OIS-implied forward.
Document ISDA master, CSA threshold, and independent amount if required.
Run settlement projection at ±25 bp rate shock before trade.
Map FRA cash flows to hedge accounting memo if electing hedge treatment.
Plan roll or swap conversion if funding date slips beyond FRA maturity.
Reconcile fixing page (e.g. NY Fed SOFR) on settlement day.
Archive trade confirmation with FRA rate, notional, and reference text.

Key takeaways

FRAs exchange a single cash settlement on the rate differential for one future accrual period — no principal is lent or borrowed through the contract.
Harbor Capital layered 3×6 and 6×9 FRAs to hedge uncertain bridge timing without swap breakage or CSA noise on undrawn notional.
t × T notation, day-count, and SOFR compounding convention must match the underlying loan or basis risk remains.
FRAs suit short, dated hedges; multi-year exposure typically migrates to swaps, caps, or swaptions.
Advance settlement discounting and convexity vs futures matter for large notionals and volatile rate environments.