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.

Answer 1

Interest rate option are similar to the option on stock where call and put options are available and the investor can speculate on the interest rate movement. Similar to the equity, the interest rate call give you the option but not the obligation to benefit from the rising interest rate and interest rate put gives the holder the option to benefit from the falling interest rate, these types of options are used by the institutional investor to hedge their positions where forward rate agreement is a contract that is signed between two parties privately, it is similar to an over the counter transaction and they are cash settled. The one major difference between the interest rate option and forward rate agreement is forward rate agreement is settled on the date of expiration while the interest rate option is settled after the exercise date of the option. These two options do have their own disadvantages as well as disadvantages and the financial manager would use these depending on his need. Lets say a financial manager wants to engage in speculation on the movement of interest rate for that purpose interest rate option would serve as a better instrument where as if the forward rate agreement acts as a counterparty agreement where the transaction can be modified according to the need of the financial manager.