Page 265 - FM Integrated WorkBook STUDENT 2018-19

Interest rate risk

Hedging interest rate risk

3.1 Forward rate agreements (FRAs)

Aim of an FRA:

 lock the company into a target interest rate

 hedge both adverse and favourable interest rate movements

Steps:

 company enters into a normal loan and separately into an FRA

 company pays interest on the loan in the normal way

 if the interest rate paid is greater than the agreed forward rate, the FRA provider
pays the difference to the company

 if the interest rate paid is less than the agreed forward rate, the company pays
the difference to the FRA provider

and vice versa for a deposit.

255