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Other parties that use forward rate agreements are speculators purely looking to make bets on future directional changes in interest rates. [2] The development of swaps in the 1980s provided organisations with an alternative to FRAs for hedging and speculating.
Interest rate futures are used to hedge against the risk that interest rates will move in an adverse direction, causing a cost to the company. For example, borrowers face the risk of interest rates rising. Futures use the inverse relationship between interest rates and bond prices to hedge against the risk of rising interest rates.
Forward rate agreement (FRA): A contract specifying an interest rate amount to be settled at a pre-determined interest rate on the date of the contract. Option (finance): similar to a forward contract, but optional. Call option: A contract that gives the owner the right, but not the obligation, to buy an item in the future, at a price decided now.
The interest rate on the loan reprices every six months. The corporation is concerned that the rate of interest may be much higher in six months. The corporation could buy a forward rate agreement (FRA), which is a contract to pay a fixed rate of interest six months after purchases on a notional amount of money. [24]
Compared to their futures counterparts, forwards (especially Forward Rate Agreements) need convexity adjustments, that is a drift term that accounts for future rate changes. In futures contracts, this risk remains constant whereas a forward contract's risk changes when rates change. [11]
Similarly, an interest rate floor is a derivative contract in which the buyer receives payments at the end of each period in which the interest rate is below the agreed strike price. Caps and floors can be used to hedge against interest rate fluctuations. For example, a borrower who is paying the LIBOR rate on a loan can protect himself against ...
The forward exchange rate depends on three known variables: the spot exchange rate, the domestic interest rate, and the foreign interest rate. This effectively means that the forward rate is the price of a forward contract, which derives its value from the pricing of spot contracts and the addition of information on available interest rates. [4]
Hedgers have an interest in the underlying asset (which could include an intangible such as an index or interest rate) and are seeking to hedge out the risk of price changes. Speculators, by contrast, seek to make a profit by predicting market moves and opening a derivative contract related to the asset "on paper", while they have no practical ...