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What Is Forward Rate Agreement

Many banks and large corporations will use FAUs to hedge future interest rate or foreign exchange risks. The buyer protects himself against the risk of rising interest rates, while the seller protects himself against the risk of falling interest rates. Other parties using forward rate agreements are speculators who only want to place bets on future changes in the direction of interest rates. [2] Development swaps in the 1980s offered organizations an alternative to FIUs for hedging and speculation. Settlement amount = interest difference / [1 + settlement rate × (days in the contract term ⁄ 360)] As stated above, the settlement amount is paid in advance (at the beginning of the contract term), while interbank rates such as LIBOR or EURIBOR apply to transactions with interest payments in arrears (at the end of the loan term). To account for this, the interest rate difference must be discounted, using the settlement rate as the discount rate. The settlement amount is therefore calculated as the present value of the interest difference: [US$ 3×9 – 3.25/3.50%p.a] – means that the deposit interest from 3 months for 6 months is 3.25% and the interest rate of the loan from 3 months for 6 months is 3.50% (see also the supply-demand gap). Entering a “paying FRA” means paying the fixed interest rate (3.50% per day) and getting a 6-month variable rate, while entering a “beneficiary FRA” means paying the same variable interest rate and getting a fixed interest rate (3.25% per day). FRA contracts are by mutual agreement (OTC), which means that the contract can be structured to meet the specific needs of the user. FRA are often based on the LIBOR rate and represent term rates, not spot rates. Keep in mind that spot rates are necessary to determine the term rate, but the spot rate is not the same as the term rate. Rate futures (FRA) contracts are associated with short-term interest rate futures (STIR futures). Since STIR futures compete with the same index as a subset of FRA, the FRA IMM, their price is interdependent.

The nature of each product has a distinctive gamma profile (convexity), which results in rational and non-arbitrald price adjustments. This adjustment is called a term convexity adjustment (FCA) and is usually expressed in basis points. [1] FIUs can be used by borrowers who want or need to adjust their interest rate or cash flow profile to their specific needs. .