What is Forward Rate Agreement?
A forward rate agreement (FRA) is a financial instrument used to hedge against interest rate risk. It is a type of over-the-counter (OTC) contract between two parties, where they agree to a fixed interest rate for a future period.
In simple terms, it is an agreement between two parties to exchange money based on a fixed interest rate on a specified future date.
In a forward rate agreement, one party is called the borrower, while the other is called the lender. The borrower is the one who wants to lock in a fixed interest rate for a future period, while the lender is the one who is willing to provide the borrower with that fixed interest rate.
Let's understand this concept with the help of an example.
Suppose, an Indian company wants to take a loan of INR 10 crores for a period of six months, starting from October 1, 2023. The company is worried about a rise in interest rates, which could increase the cost of borrowing. To hedge against this risk, the company can enter into a forward rate agreement with a bank.
The bank agrees to lend INR 10 crores to the company at a fixed interest rate of 6%, starting from October 1, 2023, for a period of six months.
By entering into this agreement, the company is protected against any increase in interest rates during the six-month period.
Even if the market interest rate rises to 8%, the company will still pay only 6% to the bank, as per the agreement.
On the other hand, if the market interest rate falls to 4%, the company will still have to pay 6% to the bank, which means the company would have paid more than the market rate. In this case, the company will incur a loss by entering into the forward rate agreement.
FAQs:
Who can enter into a forward rate agreement?
Ans: Any two parties exposed to interest rate risk can enter into a forward rate agreement. Banks, financial institutions, and large corporations typically use FRAs to manage their interest rate risk.
How is the settlement amount calculated in a forward rate agreement?
Ans: The settlement amount is calculated by multiplying the notional amount (the amount agreed upon in the agreement) with the difference between the fixed rate agreed upon and the prevailing market rate at the time of settlement.
Is a forward rate agreement a binding contract?
Ans: Yes, a forward rate agreement is a binding contract between two parties. Both parties are legally obligated to fulfill their obligations under the agreement.
Can a forward rate agreement be cancelled?
Ans: Yes, a forward rate agreement can be cancelled, provided both parties agree to the cancellation and any associated costs.
What is the difference between a forward rate agreement and a futures contract?
Ans: A forward rate agreement is a customised contract between two parties, whereas a futures contract is a standardized contract traded on an exchange. Also, futures contracts have a margin requirement, while FRAs do not.
Are forward rate agreements used in India?
Ans: Yes, forward rate agreements are used in India by banks, financial institutions, and large corporations to manage their interest rate risk.
Can a forward rate agreement be settled before the maturity date?
Ans: A forward rate agreement can be settled before the maturity date, provided both parties agree to the settlement and any associated costs.
What happens if one party defaults on a forward rate agreement?
Ans: If one party defaults on a forward rate agreement, the other party can take legal action to recover the losses.
How does a forward rate agreement help in managing interest rate risk?
Ans: By locking in a fixed interest rate for a future period, a forward rate agreement helps manage interest rate risk by providing certainty to the parties involved.
If interest rates rise in the future, the borrower is protected from paying a higher interest rate, while the lender is assured of receiving a fixed interest rate.
On the other hand, if interest rates fall in the future, the borrower may have to pay a higher rate of interest than the prevailing market rate, while the lender receives a lower rate of interest.
In this case, the borrower may have incurred a loss by entering into the FRA, but the lower interest payments on the underlying loan offset this loss.
In India, banks and financial institutions commonly use forward rate agreements to manage their interest rate risk.
Corporations also use them to hedge against interest rate risk in their debt portfolios. Forward rate agreements can be settled on a cash or delivery basis, depending on the parties' requirements.
In conclusion
A forward rate agreement is useful for managing interest rate risk. It provides certainty to the parties involved and can help protect them from adverse movements in interest rates. However, like any financial instrument, it has its risks, and parties should carefully consider the terms and conditions of the agreement before entering into it.
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