28 Nov

Forward Rate Agreement (FRA) | CA Final SFM

These are simplest forms of Interest Rate Derivatives. Under FRA, an interest rate, that is to be effected in future in agreed upon at earlier date.

For example, X Ltd. enters into FRA with IDBI Bank on 01.04.2011 that it shall borrow from the bank at the rate of 12.5% per annum interest on 01.04.2012. In this contract the amount is to be borrowed on 01.04.2012. The interest rate applicable on such borrowings has been agreed upon as on 01.04.2011.

On the date, the loan is sanctioned the interest rate prevailing in the market may not be 12.5% per annum. If interest rate prevailing in the market is more than 12.5% per annum, then X Ltd. will be benefitted by borrowing at a low rate of interest.

On the contrary, if such interest rate, prevailing in the market is lower than 12.5% per annum, X Ltd. will lose on account of high rate of interest that it will have to bear.

From the above example the following conclusions can be drawn:

  1. A benefit along with obligation: At one side X Ltd. is benefitted by borrowings at a fixed interest rate that too, agreed upon 1 year prior to the date of raising the funds; it also commits the borrowals at such agreed interest rate.
  2. The parties may not always be benefitted by entering into FRA.
  3. There is always a risk of default, i.e., parties involved in the contract may not honour such contract.
  4. FRAs are not “Exchange Regulated”.
  5. Margin Money may or may not be deposited at the time of entering into agreement.

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