Interest Rate Risk (2) Flashcards
What is forward rate agreements (FRA)?
A contract with a bank covering a specific amount of money to be borrowed over a specific time period in the future at an interest rate agreed now
Why is an FRA not identical to a forward exchange contract?
It is not an agreement that is directly linked to a transaction (e.g. lend or borrow)
How does FRA deal with interest?
It is a derivative agreement that fixes an intrerest rate on national amount of money
Similarity with FRA and forward exchange contract?
OTC transaction
FRA is a binding contract that fixes an interest rate for short-term borrowing for interest rate at future date
What if actual interest rate is higher than the FRA?
Bank supplying the FRA pays the company the difference
What if actual interest rate is lower than FRA?
The company pays the bank supplying the FRA the difference
IS FRA a hedging method?
Yes. This allows a company to take out a loan in future at the best rate available
Advantages of FRA?
Simple
Low or zero up-front costs
Fix the interest rate
Disadvantages of FRA?
Fixed date
Unattractive rate
Counter-party risk
Benefits of a fix interest rate
Protects the borrower from higher interest rates in future
How are FRAs usually available?
As large loans and are likely to be difficult to obtain for periods of over one year
