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A forward rate agreement is method of hedging against interest rate exposure on borrowings and term deposits. It is an over the counter (OTC) cash settled agreement that operates in a similar way to a futures or option contract. It allows the parties to settle the difference between the market interest rate set out in the agreement and the fixed rate at a pre-determined future date without moving the principal amount. Gains or losses are offset against each other so the parties only pay each other a net amount. For example, party A agrees with party B that party A will receive a fixed rate of 5 percent for a year on $1 million in two years time. Party B, meanwhile, will receive the one-year LIBOR rate in two years time on the $1 million. If LIBOR is at 5.5 percent after two years party A will pay a net $5,000 to party B. This is because while $1 million at 5 percent yields $50,000 for party A, $1 million at 5.5 percent yields $55,000 for party B.
See also: Derivatives