As a professional, I have written this article on the “difference between forward rate agreement and interest rate future.”
When it comes to financial markets, two types of contracts can be used to hedge against future interest rate risks: forward rate agreements (FRA) and interest rate futures (IRF). Though both involve contracts to buy or sell interest rates in the future, there are significant differences between the two.
Forward Rate Agreements
A Forward Rate Agreement (FRA) is a financial contract between two parties to buy or sell an interest rate at a predetermined date in the future. The FRA is an OTC (over-the-counter) contract between two parties, usually banks or corporations.
In an FRA, the buyer agrees to pay the seller the difference between a predetermined interest rate, known as the forward rate, and the prevailing market rate on the settlement date. The settlement date is typically six months or one year in the future. The forward rate is agreed upon when the contract is signed and is based on the prevailing market interest rate at the time of the agreement.
FRA is an important hedging tool for banks and companies looking to manage interest rate risk by locking in a fixed rate for a future period. It is also used by banks to earn a profit from a view that interest rates will increase or decrease in the future.
Interest Rate Futures
Interest Rate Futures (IRF) are standardized contracts traded on exchanges such as the Chicago Mercantile Exchange (CME). The futures contract specifies a fixed rate of interest to be exchanged for a notional principle amount on a specified date in the future. The notional amount is the benchmark for calculating the cash flows exchanged between the two parties.
IRFs involve a buyer and a seller, and the trade is guaranteed by a clearinghouse. The buyer agrees to purchase a set amount of interest rate securities on a future date at a predetermined price, while the seller agrees to sell the securities at the same price. The settlement date for an IRF is the last trading day for the contract, and the price of the futures contract reflects the expected future direction of interest rates.
IRFs are popular hedging tools for financial institutions and individual investors that want to manage their exposure to changes in interest rates. The exchange-traded nature of IRFs makes pricing transparent, and the standardization of the contracts makes them easy to trade.
Difference between FRA and IRF
The primary difference between FRA and IRF is that FRA is an OTC contract, while IRF is an exchange-traded contract. This means that FRA contracts are customized and negotiated between two parties, while IRF contracts are standard and publicly traded.
Another key difference is that FRAs usually cover a shorter term than IRFs. While FRA contracts typically cover six months to one year, IRFs cover several years. Additionally, FRA is settled on the settlement date, while IRF is settled daily.
Conclusion
In summary, both Forward Rate Agreements and Interest Rate Futures are important financial tools used to hedge against interest rate risks. The primary difference between the two is that FRAs are OTC contracts that are customized and negotiated between two parties, while IRFs are exchange-traded and standardized. While both serve similar purposes, each has its unique features and benefits.