Let's now look at how FRAs can be used in practice, for example, by borrowers who want to lock in a fixed interest rate. This is a common use case when a borrower plans to take out a short term loan in the future or wants to hedge just one period of a longer term floating rate loan.

Suppose the borrower's loan is priced at EURIBOR plus a fixed margin, and they want certainty over their all in interest cost. That's where a forward rate agreement comes in. By buying the FRA, the borrower ensures that any rise in EURIBOR above the FRA rate will be offset by a positive cash flow from the FRA.

If EURIBOR falls below the FRA rate, they'll benefit from a lower loan rate, but will pay out on the FRA. Either way, the net result is a fixed all in rate.

Let's now look at how this works using a concrete example. Imagine the borrower has agreed to a 1.5% loan margin and now locks in an FRA rate of 2%.

The table shows different possibl EURIBOR fixings at the start of the loan period alongside the resulting loan rate. The FRA settlement expressed in percentage points for easier comparison, and the borrowers all in rate after hedging. If EURIBOR fixes at 2%, the loan rate is 3.5%. The FRA settlement is zero, and the all in rate is 3.5%.

If EURIBOR rises to 5%, the loan rate jumps to 6.5%, but the FRA pays out 3%, bringing the effective cost back down to 3.5%. If EURIBOR drops to 1%, the borrower pays just 2.5% on the loan, but owes 1% on the FRA, again, ending up at an all in rate of 3.5%. So regardless of where EURIBOR ends up, the borrower locks in a constant, all in rate of 3.5% made up of the 2% FRA rate plus their 1.5% loan margin. One final thing to note, the FRA settles at the beginning of the interest period, so only the present value of the FRA settlement is exchanged. The loan interest meanwhile is typically paid at the end of the period. In practice, though this timing mismatch usually isn't a problem for most borrowers.