Using FRA, a company can hedge its interest rate risk arising on account of lending and borrowing made at fixed or variable rates. There is no actual exchange of principal amount, and the interest payments are calculated only on principal amounts.
In an FRA, the company enters into a contract with the bank for exchanging interest payments for a notional principal amount on the settlement date for a specified period from start date to maturity date.
Accordingly, on settlement date, the cash payments between the company and the bank are exchanged based on the difference between the contracted rate and the settlement rate. The settlement rate is the agreed benchmark or reference rate such as Mibor prevailing on the settlement date.
FRA thus enables a party a guaranteed future rate of interest for a specified period of time on a notional principal (loan /deposit) in the future.
While banks and financial institutions are allowed to enter into swaps for hedging their exposures as well as for market making, corporate customers are allowed to enter into FRAs only for the purpose of hedging the interest rate risk on the underlying asset/liability.
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