Forward Rate Agreement
With a Forward Rate Agreement (FRA), it is possible to hedge the current interest rate for a certain period of time in the future.
The FRA is activated separately from the underlying transaction. It can be effected or terminated at any time. All major currencies can be traded.
Hedging against Falling Interest Rates
With the sale of an FRA, the current interest rate level can be hedged for a future investment: If interest rates fall by the time the investment is made, the FRA will return a profit. The capital itself must be invested at the lower conditions, but the profit on the FRA raises the interest income to the current level. If interest rates rise, a loss is made with the FRA. However, the capital can be invested at better conditions. On the other hand, the loss reduces the interest income to the current level.
Hedging against Rising Interest Rates
With the purchase of an FRA, the current interest rate level can be hedged for a future loan: If interest rates rise by the time the loan is taken out, a profit is made on the FRA. The capital itself must be borrowed at the higher conditions, although the profit on the FRA lowers the interest costs to the current level. If interest rates fall, a loss is made on the FRA. However, the capital can be borrowed at better conditions. On the other hand, the loss lifts the interest costs to the current level.
An OTC framework agreement and a credit limit are required. The actual credit exposure is only 2 - 5% of the capital as this is not exchanged and risk is limited to possible interest rate movements over the maturity period. The lower limit for FRAs amounts to CHF 5 million or the equivalent in foreign currency.
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