Derivatives (FRA & Mechanics of Forward/Forward)

Forward Market – Deposits and Loans

  • Exist because corporations, financial institutions and banks need to borrow and lend in the future
  • Objective is to lock in the forward cost of borrowing
  • Forward rate agreements also have offer and bid rate

Forward Rate Agreement

  • An agreement between two counterparties which fixes the rate of interest that will apply to a specific notional future loan or deposit (maturing on specified future dates)
  • For borrowers to fix short term rates of interest for short term loans
  • To hedge risk of rising borrowing costs or falling lending rates

Features of FRAs

  • Cash settlement, cash compensation
  • Flexibility, notional amount
  • Lock in rate, effective lock in future interest rates for market players
  • Low credit risk, no exchange of principal, counterparty risk
  • Cancellation, cannot be canceled without agreement of both parties

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