Forward Rate Agreement (FRA) is a financial derivative that can be used to hedge against interest rate risk. Understanding this concept is essential for anyone pursuing a career in finance or accounting, and particularly for those in the Chartered Institute of Management Accountants (CIMA).
In this article, we’ll explore what forward rate agreements are, how they work, and their usage in CIMA.
What is a Forward Rate Agreement (FRA)?
A forward rate agreement is a contract between two parties, one of whom agrees to pay the other a fixed interest rate on a predetermined notional amount for a specified period in the future. The settlement of the agreement takes place at the end of the agreed-upon period.
How Does a Forward Rate Agreement Work?
Suppose a company is concerned that the interest rates will increase. In that case, it can enter into an FRA agreement with a bank, agreeing to receive a fixed rate of interest on a notional amount equal to the amount of the loan. The notional amount is the principal amount used to calculate interest, but it isn`t exchanged between the parties.
If the interest rates do increase during the period of the FRA, the company would be better off because it would receive a fixed interest rate, which would be higher than the prevailing market rate. However, if the interest rates decrease, the company would have to pay the bank the difference between the fixed interest rate and the prevailing market rate.
Usage of Forward Rate Agreement in CIMA
CIMA students need to understand the concept of FRAs since they’re essential in providing companies with financial stability and security. Companies often use FRAs to minimize the risk of fluctuations in the interest rates, which can be catastrophic if not correctly managed.
Understanding FRAs is also essential in studying and preparing for CIMA exams, especially in the Financial Management module. In this module, students learn about the different financial instruments, and FRAs are one of them. The topic is covered in more detail in the P2 performance management exam.
In conclusion, a Forward Rate Agreement is an essential tool used in finance to manage interest rate risk. As a CIMA student, understanding the concept of FRAs is vital since it’s essential in managing financial risk and is tested in the Financial Management module. Therefore, if you’re preparing for your CIMA exams, make sure you know everything there is to know about FRAs.