A forward rate agreement (FRA) is a contract between two parties who agree to fix the rate of interest on a specific notional amount for a certain period of time at a future date. FRAs are derivatives, and similar to other derivatives, the notional amount is not exchanged but rather a cash amount is based on the rate differentials and the notional value of the contract.

This type of contract is useful for managing the risk associated with changes in interest rates. When interest rates are expected to increase in the future, a borrower may wish to fix their borrowing costs by entering into an FRA. The borrower ensures the predetermined rate of interest will not be less than the agreed-upon rate, even if the general market rate of interest changes. It also allows them to lock in the borrowed amount without having to wait until the agreement comes due.

On the other hand, when interest rates are expected to decline, the lender may enter into an FRA to ensure that they will receive the agreed-upon rate of interest, even if the general market rate of interest falls. This is known as a fixed rate agreement, as the lender is securing a rate that is fixed while the other party is taking the risk of the market interest rate.

FRAs are typically used by financial institutions to hedge, or reduce, their exposures to interest rate increases or decreases prior to the date of an agreement. They are also commonly used for short-term financial investments, such as borrowing for a short-term construction project.

In conclusion, Forward Rate Agreements are an important tool for managing the risk associated with changes in interest rates. They allow both parties to enter into a contract to secure the agreed-upon rate, even if the general market rate of interest changes in the future. This is an effective way to secure a fixed-rate loan or a rate of return on a short-term investment without having to wait until the contract comes due.