Advantages And Disadvantages Of FRA

(A) Hedging with Forward

Forward rate agreement (FRA) is a forward contract that can be used to fix an interest rate for a future short-term loan or deposit. A FRA is not an actual short-term loan or deposit. In a FRA the buyer of the FRA agrees to pay a fixed rate of interest on the notional loan and in return to receive interest at the current market rate prevailing at the start of the notional loan period. On the contrary, the dealer of the FRA consents to get interest on the notional loan at the fixed FRA rate, and consequently to pay interest at the current market rate prevailing at begin of the notional loan period. Each company can buy more than one FRA to hedge the risk because of the increase in short-term interest rates. On the other

Distinct to interest rate options (for the buyer option) FRAs are binding agreements that must be settled at the settlement date. FRAs are typically more costly than similar loan cost fates contracts: future might be preferred when tailor-made agreements are redundant. Once purchased, it doesn't have a market value and can't be exchanged. Likewise with futures, FRAs don't permit purchasers or merchant to take advantage of favorable interest rate movement. (Cuthberson and Nitzsche, 2001; ACCA, 2007; Gay etal, 1983; Hull,

For example, derivatives markets produce information. In a number of countries the only reliable information about long-term interest rates is obtained from swaps because swap market is more liquid and more attractive than the bond market. In addition, derivatives allow investors to trade on the basis of information that otherwise would have been extremely expensive. Another advantage of currency swaps is that they bring together two parties who each have an advantage in a particular market. The arrangement enables each party to exploit a comparative advantage. For example, a domestic company might be able to borrow on more favorable terms than a foreign company in a particular country. There also will be legal fees for drawing up the currency swap agreement. The expenses of setting up a currency swap might make it unattractive as a hedging mechanism against currency movements in the short term. In the longer term, where there is increased risk, the swap might be cost effective in comparison with other types of derivative. In any such arrangement, there is a risk that the other party to the contract might default on the