An interest rate agreement, also known as a FRA or forward rate agreement, is a financial contract where the buyer compensates the seller if the interest rate changes from a predetermined amount. The contract involves a strike rate and a base rate, and the buyer must make a payment to the seller if the base rate exceeds the strike rate. The goal is for both parties to earn a yield, but there is a degree of risk involved.
An interest rate agreement is a type of financial contract that commits the buyer to offer some type of compensation to the seller if and when the interest rate identified in the terms of the agreement changes from a predetermined type of amount or a range of digits. Also known as a FRA or forward rate agreement, this type of contract usually includes a facility for making those payments based on the state of the rate at specific times throughout the life of the agreement. An over the counter contract of this type will involve the use of a floating or variable interest rate under the contract.
The structure of an interest rate deal will involve identifying what is known as the strike rate. This is simply the rate that serves as a standard for determining whether there is a chance that interest will become owed to the seller. Along with the strike rate, the terms of the deal will also define what is known as the base rate. The benchmark rate is the variable interest rate that can rise or fall below the strike rate and possibly trigger the need to offer some sort of interest payment to the seller.
In practice, the buyer must make some sort of payment to the seller if the benchmark rate should exceed the strike rate at specific points during the term of the interest rate agreement. Whenever the reference rate turns out to be above the strike rate at or near one of these designated time periods, a payment becomes due to the seller, based on how much the reference rate exceeds the strike rate. The process continues until the contract reaches its expiration date, at which time either party can choose to renew the deal or move on to other investment opportunities.
The idea behind an interest rate deal is to allow both parties to earn some sort of yield from the transaction. The buyer can earn more if the benchmark rate stays below the strike rate, as this means no payment is due to the seller. At the same time, the seller will often offer the asset to the buyer at a discounted purchase price, projecting that the strike rate will repeatedly increase above the benchmark rate over the life of the contract, allowing it to receive returns that compensate for the discount and provide a little extra income. Both parties assume a certain degree of risk that the arrangement will not work in their favor, making it necessary for both the buyer and the seller to project the outcome of entering into the interest rate agreement and determine whether the of risk is worth the potential returns.
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