Forward Price Rate Agreement: An Overview
Forward price rate agreement (FPRA) is a financial instrument used in risk management to protect against unfavorable movements in interest rates. It is a type of forward contract that allows two parties to agree on a fixed interest rate for a future period. FPRA is commonly used by financial institutions and corporations to hedge against interest rate risk in various financial products such as loans, bonds, and swaps.
How Does FPRA Work?
FPRA is negotiated directly between two parties – the buyer and seller – who agree on the details of the contract. The buyer agrees to pay a fixed rate of interest, while the seller agrees to pay a variable rate of interest that is based on a benchmark, such as the London Interbank Offered Rate (LIBOR). The fixed rate is set at a level that would protect the buyer against future interest rate increases, while the variable rate is set at a level that would compensate the seller for the risk of future interest rate decreases.
The contract`s term is usually between one and ten years, although it can be longer or shorter. The contract specifies the notional amount, which is the amount of money that the contract is based on. This amount does not change hands but is used for calculating the interest payments.
At the end of the contract period, the parties settle the contract by comparing the fixed interest rate agreed upon and the prevailing market interest rate. If the market rate is higher than the fixed rate agreed upon, the buyer receives a payout from the seller, which compensates for the buyer`s loss from the increase in interest rates. If the market rate is lower than the fixed rate, the seller receives a payout from the buyer, which compensates the seller for the loss from the decrease in interest rates.
Benefits of FPRA
FPRA offers several benefits, including:
1. Risk management: FPRA provides an effective way to manage interest rate risk by allowing businesses to lock in a fixed rate of interest for a future period.
2. Predictable cash flows: By fixing the interest rate, FPRA provides businesses with predictable cash flows, which helps them to plan their finances and budget effectively.
3. Flexibility: FPRA can be tailored to meet the specific needs of each party, allowing them to customize the contract to suit their individual requirements.
4. Cost savings: FPRA can help businesses save money by protecting them against future interest rate increases, which could result in higher borrowing costs.
Conclusion
FPRA is a financial instrument that allows businesses to manage their interest rate risk effectively. It is a customized contract between two parties that allows them to agree on a fixed interest rate for a future period. FPRA offers several benefits, including risk management, predictable cash flows, flexibility, and cost savings. It is an essential tool for businesses to protect themselves against adverse market movements and to plan their finances effectively.