These arrangements effectively allow a company to borrow or deposit funds as if it had agreed to a fixed rate for a set length of time. For example, the time period could begin in three months and end in nine months. Because it begins in three months and concludes in twelve, such a FRA is known as a 3 – 12 agreement. It's worth noting that both portions of the timing definition begin at the current moment.
The loans or deposits can be with one financial institution and the FRA with a different one, but the net result should be a target, fixed rate of interest for the firm. This is accomplished by adjusting monies paid to or received from the FRA's provider, according on how interest rates have fluctuated.
Interest rate derivatives
The interest rate derivatives that will be discussed are:
(i) Interest rate futures
(ii) Interest rate options
(iii) Interest rate caps, floors and collars
(iv) Interest rate swaps
Interest rate futures
Futures contracts have predetermined sizes and durations. They give its owners the option of earning income at a set rate or paying interest at a set rate.
When you sell a future, you take on the risk of having to borrow money and pay interest.
When you buy a future, you are obligated to deposit money and given the right to receive interest.
Intercontinental Exchange (ICE) Futures Europe is one of the exchanges where interest rate futures can be bought and traded.
The price of futures contracts is determined by the current interest rate, and it is important to note that when interest rates climb, the market price of futures contracts declines. Consider the following scenario: a certain futures contract allows borrowers and lenders to pay or receive interest at a rate of 5%, which is the current market rate of interest. Consider a scenario in which the market rate of interest rises to 6%. Because depositors can receive 6% at the market rate but only 5% under the futures contract, the 5% futures contract has become less appealing to acquire. The futures contract's price must fall.
Similarly, borrowers will now be required to pay 6%, but if they sell the future contract, they will only be required to pay 5%, resulting in a market with numerous sellers, lowering the selling price until a buyer-seller equilibrium price is established.
Futures prices fall when interest rates increase.
Futures prices fall when interest rates increase.
Futures prices do not always move in lockstep with interest rates in practise, hence there are flaws in the process. This is referred to as basis risk.
The method of hedging interest rates via futures is based on two parallel transactions:
At market rates, borrow/deposit.
Purchase and sell futures in such a way that any profit or loss on futures transactions offsets any loss or gain on interest payments.
As a result, borrowing or depositing can be protected in the following ways:
Making a deposit and earning interest
The depositor is concerned that interest rates may decline, reducing income.
If interest rates decrease, futures prices will climb, so purchase now (while they are still cheap) and sell later (at the higher price). The profit from futures can be utilised to make up for the reduced interest rate.
Of course, if interest rates rise, the deposit will earn more, but the futures contracts will lose money (bought at a relatively high price then sold at a lower price).
The goal, as with FRAs, is not to generate the greatest possible result, but to develop one in which the interest earned plus the profit or loss on futures deals is steady.
Borrowing and paying interest
The borrower is concerned that interest rates may rise, resulting in higher costs.
If interest rates rise, futures prices will fall, therefore sell now (while the price is still high) and purchase later (at the lower price). The profit from futures can be utilised to make up for the reduced interest rate.
Students are frequently perplexed as to how you may sell something before purchasing it. Simply remember that you are not required to deliver the contract when you sell it: it is a future contract that can be completed by purchasing in the future.
Of course, if interest rates fall, the loan will be cheaper, but the futures contracts will lose money.
Summary
The summary rule for interest rate futures is:
Depositing: buy futures then sell
Borrowing: sell futures then buy
Interest rate options
Businesses can use interest rate options to protect themselves from negative interest rate changes while also benefiting from positive ones. Interest rate guarantees are another name for them. Options are similar to insurance policies in that they provide you with a variety of choices.
To obtain the protection, you must pay a fee. Whether or whether you use the protection, this is non-refundable.
You can use the insurance if interest rates rise in an unfavourable direction.
If interest rates rise, you can afford to ignore the insurance.
Options on interest rate futures contracts provide the holder the right, but not the duty, to buy or sell the futures at a predetermined price and on a predetermined date.
Using options when borrowing
As previously stated, if simple futures contracts were used, the company would sell futures now and buy later.
The borrower takes out an option to sell futures contracts at today's price when employing options (or another agreed price). Let's say the cost is 95 dollars. A put option is a type of selling option (think about putting something up for sale).
If interest rates rise, the price of a futures contract will fall to 93. As a result, the borrower will purchase at 93 and then choose to exercise their option by selling at 95. The profit from the options is used to pay for the additional interest that must be paid. If interest rates fall, the price of a futures contract will rise, say to 97. Because the borrower is unlikely to buy at 97 and then sell at 95, the option is allowed to lapse, and the business will merely profit from the lower interest rate.
Using options when depositing
As previously stated, if basic futures contracts were used, the company would buy futures now and sell afterwards.
When an investor uses options, he or she purchases a futures contract at today's price (or another agreed price). Let's say the cost is 95 dollars. A call option is a type of purchase option.
If interest rates fall, the price of a futures contract will rise, say to 97. As a result, the investor would sell at 97 and then exercise the option to buy at 95. The gain on the options is used to compensate for the lesser interest earned. If interest rates rise, the price of a futures contract will fall to 93. Obviously, the investor would not sell futures at 93 and then exercise their option by insisting on selling at 95. The option is allowed to lapse, and the investor benefits from the increased interest rate.
As a result, options allow borrowers and lenders to guarantee a minimum income or maximum cost while allowing the prospect of a greater income or lower cost open. These 'heads I win, tails you lose' benefits must be purchased, and a non-refundable charge must be paid up advance in order to obtain the options.
Interest rate caps, floors and collars
Interest rate cap:
A cap is a method of setting a maximum interest rate for borrowers by employing interest rate alternatives. The option is permitted to lapse if the real interest rate is lower.
Interest rate floors:
A floor is a method of determining a minimum interest rate for investors by employing interest rate options. The investor will let the option lapse if the actual interest rate is higher.
Interest rate collar:
A collar is a method of limiting the amount of interest paid or earned to a pre-determined range by using interest rate choices. A borrower would buy a cap and sell a floor, offsetting the cost of the cap with the premium gained from selling the floor. A depositor would purchase the floor and sell the ceiling.
Interest rate swaps
Companies can use interest rate swaps to exchange interest payments on a notional sum for a set length of time. Swaps can be used to protect against interest rate fluctuations or to achieve a particular balance of fixed and variable rate debt.
Interest rate swaps allow both parties to gain from the interest payment exchange by obtaining lower borrowing rates than a bank would give.
Interest rate swaps are made through a financial intermediary, such as a bank, with the counterparties never meeting in person. If a counterparty defaults, the original borrower is still responsible for the original interest payments, but the counterparty risk is lowered or removed if the swap is arranged through a financial intermediary.
Swapping fixed interest payments for variable interest payments on the same notional amount is the most common sort of swap. A plain vanilla switch is what it's called.
Interest rate swaps allow businesses to hedge for a longer period of time than other interest rate derivatives, but they do not allow them to profit from favourable interest rate fluctuations.
A currency swap, which is also an interest rate swap, is another type of swap. Interest payments and principal amounts are exchanged in different currencies over a set period of time via currency swaps. They can be utilised to eliminate foreign currency loan transaction risk. A swap that exchanges fixed-rate dollar debt for fixed-rate euro debt is an example.
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