Question

The treasurer of a corporation is trying to choose between FRA and Interest Rate Futures to hedge interest rate risk. Explain these financial instruments, and discuss the advantages and disadvantages of each.

Answer 1

Treasurer of a corporation can choose between forward rate agreement and interest rate future to hedge it's interest rate risk.

Forward rate agreement means agreement between two different parties who want to protect themselves from fluctuation in interest rate in future and they enter into interest rate for future settlement based on interest and notional amount.

interest rate future are type of future contract which are based on financial instrument which pays interest and in which both parties agrees to buy and sell a debt instrument at a future date,when the future contract expires at a price which is determined today.

Advantages of interest rate futures are easy pricing, high liquidity and risk hedging.

Disadvantages associated with interest rate futures would be uncertainty and no control over the future events, different type of price fluctuations and potential reduction in the the asset price as expiration date approaches.

Advantage of Forward rate agreement are fluctuation against exchange rate and it also helps in hedging against risk and against the possibility of default .

Disadvantages of Forward rate agreement is that it is subject to default risk and contract may be difficult to cancel and there may be a difficult to find a counterparty as well as it requires tying up capital