Fundamentals of Financial Instruments, 2nd Edition

CHAPTER 14Interest Rate Derivatives

In this chapter we discuss various interest rate derivatives, both commitment and contingent, such as Forward Rate Agreements, Eurodollar Futures, Caps, Floors, Collars, Captions, and Floortions. We also examine callable and putable bonds, which are bonds with built-in interest rate options.

FORWARD RATE AGREEMENTS (FRAs)

A forward rate agreement is a forward contract on an interest rate, such as the six-month LIBOR. Because it is a forward contract, it is traded exclusively over the counter. An FRA represents an agreement between two counterparties to fix a future interest rate. These contracts are cash settled and not delivery settled. There will be a notional principal specified in the agreement, which will be used to compute the terminal cash flow. At maturity, the rate specified in the contract will be invariably different from the prevailing LIBOR. Depending on which is higher, one of the two parties will make a payment to the counterparty. For a potential borrower, the FRA locks in a borrowing rate; for a potential lender, it locks in a lending rate.

In a forward rate agreement, the party who agrees to pay the contract rate is termed the buyer, and the party who agrees to receive the contract rate is termed the seller. Such contracts may be used by hedgers as well as speculators. From a speculative standpoint, traders who are bullish about interest rates will buy FRAs. If the reference rate on the settlement date is higher than the ...