Forward Rate Agreement

The money market is a full-fledged financial market where different participants participate for different reasons. On the one hand, there are participants who invest their money for speculative reasons. This means that they want to make money from the short-term changes which take place in the money market.

On the other hand, there are participants who use the money market in order to hedge their risks. Now, whenever hedging of any kind of risk is involved, derivative instruments become necessary. This is the reason that there are some derivatives that are commonly used in the money market. The forward rate agreement is the most commonly used money market derivative instrument.

In this article, we will have a closer look at the forward rate agreement.

How do Forward Rate Agreements Work?

Forward rate agreements are derivative instruments that are mainly used to hedge the risk of short-term interest rate fluctuations. These instruments are used by government bodies as well as by corporations. Forward rate agreements may be listed on exchanges in some parts of the world. However, in most cases, these instruments are not standardized and are traded over the counter.

The forward rate agreement is an agreement wherein two parties agree to exchange the difference in interest rates. It needs to be understood that there is only a notional principal. There is no exchange of actual principal. Only the difference between the interest rates is exchanged. This derivative can be best understood with the help of an example.

A forward rate agreement assumes a notional principal, let’s say $1 million.

Now, one party agrees to pay a fixed interest rate, let’s say 5%. The other party agrees to pay the prevailing interest rate. This party is called the seller.

The other party which agrees to pay the variable interest rate is called the buyer. Now, if the prevailing interest rate is greater than 5%, let’s say 7%, then the buyer will receive 2% of $1 million i.e. $20000.

On the other hand, if the prevailing interest rate is 3%, then the buyer may have to pay $20000 to the first party. It is important to emphasize that the notional amount of $1 million never really changes hands.

Instead, it is the difference between fixed and variable rates which changes hands. The contract has to clearly state the settlement date as well as the maturity date.

The settlement date is the date on which the contract is assumed to have begun. On the other hand, the maturity date is the date when the contract expires and the exchange of interest rates needs to be undertaken.

The forward rate agreement is basically a bet on the future interest rate in the short term. Since most investors in the money market are making bets which include predicting the level of short-term interest rates, they can use this derivative instrument either to hedge their existing bets or to make new bets.

Advantages of Forward Rate Agreements

1. The biggest advantage of forward rate agreements is the liquidity that the market provides. There is always a large number of buyers and sellers who are looking to buy and sell these instruments. Hence, it is very easy to open a position or square off an open position by opening a reverse position. Investors do not have to incur a large number of transaction charges while getting in or out of such agreements.

2. The market is quite flexible and allows investors to obtain forward rate agreements for different amounts. Investors who have relatively small exposures can also easily use this instrument in order to hedge their potential losses.

3. A very important feature of forward rate agreements is the fact that these transactions are all managed off the balance sheet. Hence, companies are able to take a position or hedge an open position without depicting any impact on their financial statements. The ability to keep the transaction off the balance sheet is quite valuable for many investors.

Disadvantages of Forward Rate Agreements

1. Forward rate agreements are essentially an agreement between two parties. It is possible that both of these parties will be private parties with no sovereign backing. Hence, there is always a likelihood of there being a credit risk associated with the transaction. It is quite possible that the other party does not have the funds to honor the contract. Since the transaction generally takes place over the counter, the margin trading and other risk control mechanisms also do not work very effectively.

2. There is always a basis risk associated with such contracts. This is because these contracts are often sold for fixed maturities such as one month, three months, or six months duration.

   However, the actual investment does not follow these time frames. Hence, there is always a chance that the investor is exposed to the effects of the derivative even though they do not have any underlying asset. In such cases, the position is completely speculative.

The bottom line is that forward rate agreements are the most commonly used derivative instrument in the money market. They are vital to the survival of money market investors since they help investors hedge their risks which further enable them to use sophisticated trading strategies.

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