6
OTC products
We have already noted elsewhere in the book that the OTC derivative
market is a large and important one. In this chapter we can look at
some of the popular types of OTC products.
Forward rate agreements
A forward rate agreement (FRA) is an agreement to pay or receive, on
an agreed future date, the difference between a fixed interest rate at
the outset and a reference interest rate prevailing at a given date for
an agreed period.
The FRAs are transacted between buyers who agree to the fixed
rate and sellers who agree to the floating rate or benchmark.
The benchmark rate will be, for instance, LIBOR and the settlement
is calculated using a formula.
Example
Suppose a manufacturer needs to borrow £5 million in one-month
time and needs the loan for a period of three months. Concerned
about the raising of interest rates, the manufacturer decides to
buy an a FRA that will fix the effective borrowing rate today. They
do this as they have no wish to borrow the money now when it is
not needed but do not want to have to pay a higher funding cost if
rates rise in the next month.
The terms of the FRA are that the fixed rate is 7.25 per cent and
the benchmark is LIBOR. It will start in one-month time and finish
three months later and would be known as a ‘one v four’ FRA.
In one-month time, the calculation of the settlement of the FRA
can take place. The prevailing LIBOR at 11.00 a.m. is used and let
us assume this as 7.5 per cent.
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