Let's now look at how RAs 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 your i 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 your IB above the FRA rate will be offset by a positive cash flow from the FRA.
If your eyeball falls below the FRA rate, they'll benefit from a lower loan rate, but will pay out on the FRA.
Either way, the knit 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 one and a half percent loan margin and now locks in an FRA rate of 2%.
The table shows different possible your IB 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 your eyeball fixes at 2%, the loan rate is 3.5%.
The FRA settlement is zero, and the all in rate is three point a 5%.
If your eyeball 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 your eyeball drops to 1%, the borrower pays just two and a half percent on the loan, but owes 1% on the FRA, again, ending up at an all in rate of 3.5%.
So regardless of where your IO ends up, the borrower locks in a constant, all in rate of 3.5% made up of the 2% FRA rate plus their one and a half percent 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.
