TABLE OF CONTENTS The market in short-term interest rate derivatives is a large and liquid one, and the instruments involved are used for a variety of purposes. In this chapter we review the two main contracts used in money markets trading, the short-term interest rate future and the forward rate agreement. Money market derivatives are priced on the basis of the forward rate, and are flexible instruments for hedging against or speculating on forward interest rates. The FRA and the exchange-traded interest rate future both date from around the same time, and although initially developed to hedge forward interest rate exposure, they now have a variety of uses. In this chapter the instruments are introduced and analysed, and there is a review of their main uses.
A forward rate agreement (FRA) is an OTC derivative instrument that trades as part of the money markets. It is essentially a forward-starting loan, but with no exchange of principal, so that only the difference in interest rates is traded. An FRA is a forward-dated loan, dealt at a fixed rate, but with no exchange of principal only the interest applicable on the notional amount between the rate dealt and the actual rate prevailing at the time of settlement changes hands. So FRAs are off-balance sheet (OBS) instruments. By trading today at an interest rate that is effective at some point in the future, FRAs enable banks and corporates to hedge interest rate exposure. They may also be used to...
