Question

explain the pros and cons of interest rate forward contracts

Answer 1

An interest rate forward contract is a contract that involves the sale of a debt instrument on a pre-specified future date at a pre-specified rate of interest. These contracts involves details regarding the debt instrument(s), amount of the instrument that will be delivered, due date of the debt instruments, forward date (i.e. due date of the contract), rate of interest on the debt instrument to be delivered.

The advantage of interest rate forward contracts is that they are flexible i.e., they can be as flexible as the parties involved want them to be. This means that a banking institution may be able to hedge completely the interest-rate risk for the exact security it is holding in its portfolio.

The disadvantage of interest rate forward contracts is that it is difficult for a financial institution such as banks to find a counterparty who wants to make a specific type of forward contract. It may be very hard for an institution like bank to find another party (called a counterparty) to make the contract with. Such a disadvantage limits the use of interest rate forward contracts. Even if it finds a counterparty, it may not get as high a price as it wants because there may not be anyone else to make the deal with. A major problem for the market in interest-rate forward contracts, then, is that it may be difficult to make the financial transaction or that it will have to be made at a disadvantageous price; in the parlance of financial economists, this market suffers from a lack of liquidity. Another disadvantage attached with interest rate forward contracts is that they are subject to default risk i.e, there is no outside party guaranteeing the transaction. The contracting party may fail to perform the contract due to interest rate changes. In order to avoid such risk the parties to these contracts must check each other out to be sure that the counterparty is both financially sound and likely to be honest and live up to its contractual obligations. Both of these disadvantages namely, lack of liquidity and default risk problem limits use of these contracts for financial institutions. Due to these disadvantages only they are not much preferred by the financial institutions.