Despite you consider yourself as an organization or as individual, interest rate is one of the many factors that can affect you irrespective of you being the lender or the borrower. A company or an individual with variable or a fixed rate of interest face the interest rate risk due to the fluctuations in the interest rate that with the movements in the economy.

The variable rates that are offered by a bank are based on a base rate like LIBOR ( London Inter Bank Offer Rate ) or SLIBOR in Sri Lanka. The rates represent the rate at which the financial institutions are willing to lend each other. Banks use the LIBOR or (SLIBOR) as the starting point for their funds ( Since the SLIBOR or LIBOR represent an opportunity cost - They could have lend at that rate ) and as a result, any variable rate borrowing is affected by the movements in the LIBOR.

SLIBOR

LIBOR

On the otherhand, if you elect to move with the fixed rates, your borrowings would be expensive if the LIBOR moves down or your your benefits on savings would be less if LIBOR goes up. Thus it is obvious that you will have to take actions to minimized the possible loss of benefit to your organization, if it intends to lend or borrow.

For explaining the scenario, let us consider an organization X requiring $10m on 1/4 for 6 months and today to be 1/1 and financing is to be obtained from bank Y.

Forward Rate Agreements (FRA)

In a FRA, X goes ahead to the bank and asks for the $10m 3 - 9 FRA and X needs to buy a FRA from the bank. If X is anticipating cash surplus and willing to deposit the money for 6 months, then X will have to sell FRAs to a bank.In the terminalogy of FRAs, you will have to specify the amount, starting time and the ending time for the FRA.

Once X asks to buy a FRA, the bank Y will quote two percentages, for instance as 4%-5%. The rates the bank quote relate to the rates that the bank is willing to offer for the deposits and borrowings. X being a borrower will therefore get the higher tate out of the quoted rates, in this case X will get 5%.

The quoted rate in a FRA doesn’t mean that the buyer is able to borrow at the rate, rather rate guarantees the borrower a base rate. For instance if X goes ahead and buys the FRAs to borrow at 3% premium, then X is guaranteed a rate of 5% + 3% = 8% even if the LIBOR goes above 5%.

On the otherhand, the agreement is a binding agreement, X will have to borrow at the higher rate even if the interest rates goes down. For instace consider the situation when the LIBOR drops to say 3%, In such a situation, the agreement would not be benificial to X. To tackle such scenarios, the FRAs can be bought with the option of declining the agreement but with premium. In such agreement X can exercise the option if the rates higher or forget if the interest rates fall below.

In a nutshell, a FRA with an option of declining would provide a borrower with a guaranteed ceiling for the interest rate. In the case of a lender, you can use the FRA to guarantee a floor interest rate for the savings.

Swaps

FRAs are forward looking - they are planned before the borrowing or lending. Swaps are usually exercised after such a borrowing or lending. For instace suppose X borrowed $10m on a variable rate and wants to change it to fixed. For changing the loan from variable to fixed rate would incur a significant cost to X such as early settelement fees, transaction fees and processing fees.

Swaps are financial arrangements that are suited for such situations. In a typical swap ( assume a borrowing swap ) a bank make arrangemet between two parties who are willing to swap the interest rate costs with each other subjected to a fee from the bank. In the above example X can find Z ( another organization) who have taken a borrowing at a fixed rate expecting to settle for a variable rate.

In a swap, the borrowed amounts of both parties should be equal, otherwise both parties can settle for the lower of two borrowings. However in the real world, if you are anticipating fixed rates to benefit you, others would also anticipate the same scenario making it harder to find another party to swap.

Cheers !!!

mahanama94