Question

Compare the use of interest rate option with forward rate agreement. Explain
why a financial manager might prefer one type of contract over another.

URGENT CAN ANYONE ASSITS ME

Answer 1

^{Answer :}

^{Meaning of Interest Rate Option :}

^{The  financial derivative which allows the holder to earn profit  from changes in interest rates is known as Interest Rate Option .Here Investors can speculate in the direction of interest rates with interest rate options. It is like to an equity option thus  can be either a put or a call. Interest rate options are option contracts on the rate of bonds like U.S. Treasury securities.}

^{Meaning Of Forward Rate Agreement ( FRA) :}

^{It is a cash-settled OTC contract between two counterparties, where the buyer is borrowing and the seller is lending a notional sum at a fixed interest rate (the FRA rate) and for a specified period of time starting at an agreed date in the future.}

^{An FRA is basically a forward-starting loan, were Principal is not exchange between Buyer & seller. The notional amount is simply used to calculate interest payments. It als market participants to trade today at an interest rate that will be effective at some point in the future, It allows them to hedge their interest rate exposure on future engagements.}

^{Due To following Advantages of Interest rate derivatives Finacial manger can opt above Forward Rate Agreements}

1. ^{Interest rate derivatives are opted for adjustments of portfolios}
2. ^{They are more liquid compared to the underlying instrument}
3. ^{They help in lowering the cost of funding}
4. ^{Speculative positions can be taken in context to future movement in interest rates}
5. ^{They can provide yield irrespective of the market conditions}
6. ^{Market participants use interest rate derivatives either to hedge the risk or take future positions}
7. ^{It helps in mitigating the risk from unpredictable interest rate swings (risk diversification instrument)}

^{Were as Forward Rate Agreement has following major Disadvantages which makes it less attractive.}

1. ^{no possibility of benefiting from a favourable interest rate fluctuation between the determination date and the settlement date (due date);}
2. ^{separation from the underlying loan (investment), meaning that the hedging continues to be effective even if the underlying no longer exists.}
3. ^{There is a risk of the other party defaulting on their settlement payment. This is the credit risk involved.}
4. ^{The lack of a formal market can make it difficult to close out a position on a FRA.}