The names “Forward Contract” and “Forward Rate Agreement” (FRA) may sound similar, but they play distinct roles in financial markets, differing in key characteristics and functions. Let’s explore the main differences between these financial instruments.
| Elements | Forward Contract | Forward Rate Agreement (FRA) |
| Parties in the Contract | Forward contracts are agreements between two parties — buyers and sellers — to trade a specified asset at a future date for a pre-agreed price. (Assets including stocks, bonds, mutual funds, derivatives, and foreign exchange.) | FRAs are contracts between two parties to exchange interest payments at a future date. |
| Trade | Forward contracts are over-the-counter (OTC) instruments, meaning they are directly negotiated between two parties and not traded on a centralized exchange like a stock market. | FRAs are also OTC-traded derivatives, directly negotiated between parties and not traded on centralized exchanges. |
| Nature of Agreement | Forward contracts are private agreements to buy or sell an asset at a predetermined price on a future date. | FRAs allow one party to hedge against potential interest rate changes by fixing the interest rate for a future period. The borrower agrees to pay a fixed interest rate, while the lender receives it. |
| Risk Cover | Forward contracts help mitigate the risk of price volatility for an asset. | FRAs hedge against interest rate changes and manage interest rate risk. |
| Use | Forward contracts can be used for speculation but are primarily suited for hedging due to their non-standardized nature. | FRAs are typically used to manage short-term interest rate exposures and hedge borrowing costs or investment returns. |
| Advantages | Forward contracts lock in specific prices to avoid price volatility. The party who buys a forward contract is entering into a long position*, and the party selling a forward contract enters into a short position. The long position benefits when the underlying asset’s price rises, while the short position benefits when it falls. *(A long position in trading is when you buy an asset with the expectation that its price will increase in the future. For example, if you buy 100 shares of a stock at Rs.80 per share and the price increases to Rs.85 per share, you’ll make a profit of Rs.500). | FRAs allow parties to tailor interest rate profiles to suit their needs and protect against adverse interest rate movements. |
| Disadvantages | Listed below | Listed below |
Disadvantages of Forward Contracts:
Forward contracts have several downsides, including:
- Exposure to unfavorable price movements of the underlying asset.
- Counterparty risk: One party may default on obligations.
- Liquidity risk: Finding counterparties or exiting positions can be challenging.
- Default risk: Less regulation compared to futures contracts.
- Difficulty finding counterparty.
- No benefit from favorable currency exchange rate shifts.
- Inability to exit before the expiry date. | FRAs have the following disadvantages:
- Potential cash settlement loss if market rates move against the borrower.
- Limited flexibility: Contracts are binding and cannot be modified.
- Missed opportunities from favorable interest rate changes.
- Lower regulation and oversight than futures contracts.
- Counterparty risk: Higher risk of default. |
Disadvantages of Forward Rate Agreement:
A Forward Rate Agreement (FRA) has several disadvantages, including:
- Loss on cash settlement: If the market rate moves against the borrower, they may lose money on the cash settlement.
- Limited flexibility: FRAs are binding contracts that can’t be changed or modified once entered into. This can be a disadvantage if market conditions change.
- Missed opportunities: The borrower may miss out on favorable interest rate fluctuations between the determination date and the settlement date.
- Lower regulation: FRAs have less regulation and oversight than futures contracts.
- Counterparty risk: FRAs have higher counterparty risks.
Summary
The forward market allows contract parties to customize the time, amount, and rate at which the contract is to be performed.
Related Posts:
