TREASURY CLASSROOM VOLUME 126

FORWARD RATE AGREEMENT

Now it's an interest rate derivative that is used to hedge the interest rate risk especially when Some companies are taking External commercial borrowing now if they are taking External Commercial Borrowing then you will be exposed to the Interest rate risk which is LIBOR. Although there are other interest rate hedging tools available like Coupon only swaps, Interest rate caps, and floors.

Now the beauty of the Forward rate agreement is that you can hedge the assets and liabilities that are yet to enter into the books. And also on the assets side, you will Sell FRA and on the liabilities side, you will Buy FRA. And in this, the convention goes like this suppose you want to take the Loan after 2 months down the line for one year then it will be termed as 2*14 means after the 2 months you need to take the one-year loan.

Suppose there is a company named XYZ Ltd and they know that they will be needing the loan 2 months down line for one year that is for 12 months. And also assuming that they are of the view that Libor will move up. Suppose currently 1-year LIBOR is 3%. So they go to the bank and buy an FRA for 2*14 at 3%. And also suppose 2 months down the line one year LIBOR has gone up around 4% then the bank will pay the difference to the company. Now in this case they have a benefit of 1% by taking a position through FRA. Now As they want the benefit at present. So the value will be discounted. Suppose the notional amount in which they have taken the loan is around $1million.

Now the contract period is of 1 year in that case interest rate differential will be around (3%-4%)*$1000000*x/365= $10000

X would be no of days here it would be one as the no of days would be 365. Now the catch is that we have to also calculate the present value of this $10000 as this $10000 you are getting after 2 months so that's why the present value.

Present value - $10000/(1+0.04)^365/365= $9615.38

This $9615.38 will come on the credit side of the profit and loss statement.

Forward rate agreement is one of the most liquid markets that we have.

Also, there are other interest rate derivatives tools that are Interest rate caps and floors

INTEREST RATE CAPS, FLOORS, AND COLLARS

Interest rate caps and floors are considered to be interest rate options. Let's understand

Suppose a firm borrows at a floating rate and its risk is like if suppose interest rate rise. Now such a case the firm can buy the Interest rate cap to protect itself from the rising interest rate.

Suppose the firm is expecting to invest in floating rates then they are worried about the interest rate declining. Now in this situation, they will buy the Interest rate floor to prevent the risk of interest rate falling.

Generally, the Interest rate combination of caps and floors are called Interest rate collars