Forward rate agreements to hedge the risk of interest rate fluctuation

This page was last modified on 21-01-2013

A forward rate agreement is a forward contract, the purpose of which is to set an interest rate for a future transaction. It is an over-the-counter agreement entered into by 2 parties, which, once it is concluded, guarantees the borrower and the lender a fixed interest rate for a specific period and on a specific amount. 

The buyer of a forward rate agreement is referred to as the borrower. The borrower hedges against an unfavourable fluctuation, i.e. a rise in interest rates, by setting a future interest rate today for a specific period and amount by concluding a forward rate agreement.

The seller of a forward rate agreement is referred to as the lender. The lender hedges against an unfavourable fluctuation, i.e. a fall in interest rates, by setting a future interest rate today for a specific period and amount by concluding a forward rate agreement.

Who is concerned

Available mainly to medium and large businesses, a forward rate agreement applies in the following cases:

  • instrument for hedging an investment (sale of a forward rate agreement):
    • setting the current interest rate for a future investment (inflow of cash);
  • instrument for hedging a loan (purchase of a forward rate agreement):
    • setting the interest rate for standard credit or loans with a variable or adjustable rate (roll-over credit);
    • setting a lending rate to finance an investment that is planned but not yet carried out, etc.

Prerequisites

Presentation of the application

Explanation of the underlying financial transactions to the bank.

Guarantees

Some interest rate hedging transactions represent a credit risk for banks, causing them to analyse the applicant business and submit the application to the credit committee. It is not, however, customary for the bank to request tangible guarantees for this type of transaction.

How to proceed

Application

Amount

A minimum amount is generally required to be able to access forward agreements.

Duration

  • short to medium-term;
  • the duration does not generally exceed 2 years.

Payment of a balancing amount or differential

At maturity, the market interest rate of the day is compared to the agreed interest rate:

  • if the agreed rate is higher than the market rate of the day, the buyer must pay the seller an amount equal to the difference between the 2 interest rates;
  • if the agreed rate is lower than the market rate of the day, the buyer will receive an amount equal to the difference between the 2 interest rates from the seller.

The amount to be paid is calculated on the basis of the notional amount and for the period of the agreement.

Set-up times

The reviewing and processing times depend on the complexity, size and urgency of the case.

Advantages, disadvantages and risks

Advantages

  • the borrowing (lending) business is protected against an excessive rise (fall) in interest rates by a guaranteed maximum (minimum) rate;
  • no early repayment or even renegotiation of the underlying credit agreements with the bank;
  • simple and easy to process: the bank credits or debits the customer’s account depending on rate fluctuations;
  • possibility of reversing the transaction at any time given that it is a very liquid market;
  • easy to manage, recorded off-balance sheet for the business.

Disadvantages

  • no possibility of benefiting from a favourable interest rate fluctuation between the determination date and the settlement date (due date);
  • separation from the underlying loan (investment), meaning that the hedging continues to be effective even if the underlying no longer exists.

Risks

  • exchange rate risk in the case of an unhedged agreement in a foreign currency;
  • credit risk (because an over-the-counter agreement involves the risk of counterparty default).