Forward rate agreements (FRAs) are a type of financial instrument that allows two parties to enter into a contract for the delivery of a certain amount of money at a predetermined interest rate on a future date. They are commonly used to hedge against fluctuations in interest rates, and are an important topic for those studying for the CFA level 2 exam.

At its most basic level, an FRA involves two parties: the buyer and the seller. The buyer agrees to pay a fixed interest rate on a specific amount of money on a future date, while the seller agrees to pay the interest rate that is prevailing on that date. The difference between the two rates is settled in cash.

FRAs are typically used by banks, financial institutions, and large corporations as a way of managing interest rate risk. For example, a company may use an FRA to protect itself against the risk of rising interest rates, as this could make it more expensive for it to borrow money in the future. By entering into an FRA, the company can lock in a fixed interest rate, providing certainty and stability in its financial planning.

For those studying for the CFA level 2 exam, it is important to understand the mechanics of FRAs, as well as their use cases and limitations. One key concept to understand is the pricing of FRAs, which is based on the prevailing interest rates at the time the contract is entered into. Additionally, candidates should be aware of the various types of FRAs, which can be cash-settled or physically settled, and can be quoted in different currencies.

When preparing for the CFA level 2 exam, candidates should familiarize themselves with the various calculations involved in FRAs, including calculating the forward rate, the implied interest rate, and the settlement amount. It is also important to understand the risks associated with FRAs, which include the possibility of interest rates moving in ways that are unforeseen or unexpected.

In conclusion, forward rate agreements are an important financial instrument for managing interest rate risk, and are a key topic for those studying for the CFA level 2 exam. By understanding the mechanics of FRAs, their use cases, and their limitations, candidates will be well-equipped to succeed in this area of the exam and in their future careers in finance and investment.