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Forward Rate Agreements

ACCA P4考试:Forward Rate Agreements
Forward rate agreement (FRA)— an agreement by a bank to enter into a notional loan or accept a notional deposit from a customer for a specified period of time. The contract is settled based on the difference between the interest rate agreed when the contract is signed and the rate prevailing when the notional loan/deposit is deemed to start.
FRAs allow companies to fix, in advance, either a future borrowing rate or a future deposit rate, based on a notional principal amount, over a given period.
FRAs are settled in advance (i.e. when the notional loan/deposit is deemed to start). The settlement is based on the difference on settlement date between: the rate fixed in the contract; and the reference interest rate (e.g. LIBOR).
FRAs are therefore cash settled rather than requiring physical delivery.
The maximum maturity period for an FRA is usually about two years.
FRAs are customised agreements with a bank (i.e. OTC).
No premium is paid for an FRA and no margin needs to be posted.
Although no money changes hands when an FRA is signed, the words "buy" and "sell" are still used:
Buying an FRA—represents taking a notional loan from the bank at a fixed borrowing rate. Hence a company would buy an FRA to hedge against rising interest rates.
Selling an FRA—represents making a notional deposit at the bank at a fixed rate. A company would sell an FRA to hedge against falling rates.
If the company buys an FRA it will be offered a higher rate than if it sells an FRA. The bank makes its profit by applying a spread to the rates; this is where the cost of hedging for the company is "hidden".

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