Forward Rate Agreements Interest Rate Options and Caps and Collars

Forward rate agreements. Under a forward rate agreement (FRA) the seller agrees to lend to the buyer a specified amount of funds, in a specified currency, for a specified period starting at a specified future date, at a predetermined rate of interest. For instance, a bank may agree to lend three months hence USD 100,000 at 6% for a period of six months. On the settlement date (three months from the date of contract), however, the bank does not actually lend this amount to the buyer.

If the market rate on that date is higher than the agreed rate, the bank pays the difference to the buyer. If the market rate happens to be lower than the agreed rate, the buyer compensates the bank for the difference.

FRAs are available in international markets in all convertible currencies and with individual banks. The minimum principal amount is around 5 million units of a currency.

Interest rate options. Interest rate options allow the buyer of the option to borrow or lend the specified amount of a specified currency at a specified future date at a specified rate of interest, without any obligation to do so. This product is available on payment of up-front fee called the premium. A call option invests the buyer with right to borrow and a put options investĀ  him with right to invest.

An interest rate cap consists-of a series of call options on interest rate cover-ing a medium-to-long term floating rate liability. For instance, a company which has borrowed a three year foreign currency loan on which interest is payable half-yearly at LIBOR plus 1%, may enter into a series of five call options with maturity dates coinciding with the due dates for payment of interest commencing from second due date.

The interest payable for the first six months is known and hence no option is required. if the rate of interest on a due date happens to be higher than the strike rate (agreed rate under the option), the company can exercise the option and hence limit the cost to the strike rate.

If the rate of interest reset at a due date turns out to be lower, the option may not be exercised thereby reaping the benefit of lower interest rate. An interest rate floor is a series of put options meant to protect the lender against drop in the interest below a specified rate in a floating rate asset. An interest rate collar is a combination of a cap and a floor.

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