Forward Rate Agreement Synthetic: What It Is and How It Works
Forward Rate Agreement Synthetic, or FRAS, is a financial instrument used by investors and traders to manage interest rate risk. It is a type of derivative that allows parties to hedge against fluctuations in interest rates by locking in a fixed rate for a future period.
What is a Forward Rate Agreement?
Before diving into FRAS, it`s important to understand what a Forward Rate Agreement, or FRA, is. An FRA is a contract between two parties where one party agrees to pay the other a fixed rate of interest on a notional amount for a predetermined period of time in the future. The fixed rate agreed upon is based on the prevailing market interest rate at the time the contract is entered into.
For example, let`s say that a company wants to borrow money in six months and is concerned that interest rates will rise during that time. They can enter into an FRA with a counterparty who agrees to pay them a fixed rate of interest for the six-month period, effectively locking in the interest rate. If interest rates do rise, the company will receive the fixed rate from the counterparty, which is higher than the prevailing market rate, and will effectively save money on interest expenses.
What is a Forward Rate Agreement Synthetic?
A Forward Rate Agreement Synthetic, or FRAS, is essentially a combination of an FRA and a swap. It involves two parties exchanging fixed and floating interest rate payments based on a notional amount for a predetermined period of time in the future. The fixed interest rate is determined by an FRA, while the floating rate is based on a benchmark interest rate, such as LIBOR.
FRAS can be used to hedge against interest rate risk in much the same way as FRAs, but they offer more flexibility in terms of the notional amount and the tenor of the contract. They also provide more precise hedging as they allow investors to customize the terms of the contract to match their specific needs.
FRAS are often used by banks and financial institutions to manage interest rate risk in their portfolios. They can also be used by companies to hedge against interest rate risk in their borrowing and lending activities.
The Bottom Line
Forward Rate Agreement Synthetics, or FRAS, offer investors a flexible and customizable way to hedge against interest rate risk. They allow parties to lock in fixed rates for a future period while also providing the option to customize the terms of the contract to match their specific needs. While FRAS are a more complex financial instrument than FRAs, they offer more precision in terms of hedging and are commonly used by banks and financial institutions to manage interest rate risk in their portfolios.
