explain the pros and cons of interest rate forward contracts

Expert Solution

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.

Rahul Sunny answered 2 years ago

What are the pros and cons of the “zero interest rate policy” (i.e., very low interest...

What are the pros and cons of the “zero interest rate policy” (i.e., very low interest rates) of the Fed, from the perspective of the car industry?

1. Describe Interest Rate Parity (IRP). 2. Compare and contrast forward and futures contracts. 3. Explain...

1. Describe Interest Rate Parity (IRP). 2. Compare and contrast forward and futures contracts. 3. Explain how firms can benefit from forecasting exchanges rates. 4. Describe the common techniques used for forecasting exchange rates. 5. Explain the concepts of transaction exposure, economic exposure, and translation exposure. How each of the exposure could be measured? 6. Describe the commonly used techniques to hedge payables and receivables. 7. Suggest other methods of reducing exchange rate risk when hedging techniques are not available....

Identify 3 pros and 3 cons of localization and standardization and explain why they are pros/cons....

Identify 3 pros and 3 cons of localization and standardization and explain why they are pros/cons. Give 2 examples of products that are better off with Standardization and 2 that are better off with Localization and explain why?

Explain the pros and cons of liberalized exchange rate system in the context of Tanzania Derive...

Explain the pros and cons of liberalized exchange rate system in the context of Tanzania Derive and explain the monetary approach to the balance of payments. Explain the economic benefits of capital markets

explain how forward contracts differ from futures contracts? As it relates to future contracts, explain your...

explain how forward contracts differ from futures contracts? As it relates to future contracts, explain your understanding of marking to market.

Describe the pros and cons of a fixed exchange rate system.

Please explain the pros and cons of fiat currencies

DB Mergers and Acquisitions: Pros and Cons A look at the pros and cons of mergers...

DB Mergers and Acquisitions: Pros and Cons A look at the pros and cons of mergers Are mergers in the public interest or are mergers just beneficial for top executives and shareholders? Provide an example of a recent corporate merger and discuss how that merger affected competition, economies of scales, consumer prices, and consumer choice.

A Detailed Pros and Cons analysis with at least 7 Pros and 5 Cons of the...

A Detailed Pros and Cons analysis with at least 7 Pros and 5 Cons of the Strategic Action. This section should lead with statement that, describes what the strategic action is, what primary level or secondary level strategy the action is meant to achieve, and how that fits with the firm’s Generic Strategy. Then the Pros and Cons will help you evaluate how well the strategic action fulfills the strategy. The pros and cons should not be vague positives from...

List pros and cons of the constant money growth rate rule.

Question