Forward Rate Agreement

In finance, a forward rate agreement (FRA) is a forward contract in which one party pays a fixed interest rate, and receives a floating interest rate equal to a reference rate (the underlying rate). The payments are calculated over a notional amount over a certain period, and netted, i.e. only the differential is paid. It is paid on the effective date. The reference rate is fixed one or two days before the effective date, dependent on the market convention for the particular currency. FRAs are over-the counter derivatives. A swap is a combination of FRAs.

Many banks and large corporations will use FRAs to hedge future interest rate exposure. The buyer hedges against the risk of rising interest rates, while the seller hedges against the risk of falling interest rates. Other parties that use Forward Rate Agreements are speculators purely looking to make bets on future directional changes in interest rates.

The payer of the fixed interest rate is also known as the borrower or the buyer, whilst the receiver of the fixed interest rate is the lender or the seller.

The FRA can be used

• By market participants who wish to hedge against future interest rate risks by setting thefuture interest rate today (at trading date)

• By market participants who want to make profits based on their expectations of the future development of interest rates

• By market participants who try to take advantage of the different prices of FRAs and other financial instruments, e.g. futures, by means of arbitrage.

FRAs are over the counter (OTC) products and are available for a variety of periods: starting from a few days to terms of several years. In practice, however, the FRA-market for 1-year FRAs offers the highest liquidity and is therefore also regarded as a money-market instrument.

The FRA is not an obligation to borrow or lend any capital in the future. At settlement date, the principal just serves as the basis to calculate the difference between the two interest rates, or rather the settlement payment that results from this difference.

Collar

A collar is an investment strategy that uses options to limit the range of possible positive or negative returns on an investment in an asset to a specific range. To do this, an investor who owns an asset simultaneously buys a put option and sells (writes) a call option on the same asset. The strike price on the call needs to be above the strike price for the put, and the expiration dates should be the same.

After establishing the portfolio in this manner, the market value of the portfolio will be between the strike price on the call and the strike price on the put. Thus possible gains and losses (the value of the portfolio minus the cost of acquiring it) are confined within a specified range.

1. A way to hedge against the potential of loss by buying an out-of-the-money put while writing an out-of-the-money call. A collar is most beneficial when an investor holds a stock that has recently experienced significant gains. If the stock falls, the investor can exercise the put, ensuring a profit. If it continues to rise, the call places a cap on the profit.

2. On an exchange, a measure designed to prevent panic selling by stopping trading after a security or an index has fallen by a certain amount. For example, if the Dow Jones Industrial Average falls 10% in a trading day, the New York Stock Exchange suspends trade for at least one hour. A collar is intended to allow investors to determine whether a situation is really as bad as it looks. It is sometimes called a circuit breaker.

Why do this?

In times of high volatility, or in bear markets, it can be useful to limit the downside risk to a portfolio. One obvious way to do this is to sell the stock. In the above example, if an investor just sold the stock, the investor would get $5. This may be fine, but it poses additional questions. Does the investor have an acceptable investment available to put the money from the sale into? What are the transaction costs associated with liquidating the portfolio? Would the investor rather just hold onto the stock? What are the tax consequences?

If it makes more sense to hold on to the stock (or other underlying asset), the investor can limit that downside risk that lies below the strike price on the put in exchange for giving up the upside above the strike price on the call. Another advantage is that the cost of setting up a collar is (usually) free or nearly free. The price received is used for selling the call to buy the put—one pays for the other.

Finally, using a collar strategy takes the return from the probable to the definite. That is, when an investor owns a stock (or another underlying asset) and has an expected return, that expected return is only the mean of the distribution of possible returns, weighted by their probability. The investor may get a higher or lower return. When an investor who owns a stock (or other

underlying asset) uses a collar strategy, the investor knows that the return can be no higher than the return defined by strike price on the call, and no lower than the return that results from the strike price of the put.

How Protective Collars Work

This strategy is often used to hedge against risk of loss on a long stock position or an entire equity portfolio via the use of index options. It can also be used to hedge interest rate movement by both borrowers and lenders by using caps and floors.

Protective collars are considered a bearish to neutral strategy. The loss in a protective collar is limited, as is the upside. Should the collared position increase above the strike price of the short call, the investor will lose the upside potential - or suffer an opportunity cost.

Equity Collars

An equity collar is created by selling an equal number of call options and buying the same number of put options on a long stock position. The premium from the sale of the call is applied toward the put purchase, thus reducing the overall premium paid for the position. Market pundits recommend this strategy when there is neutrality following a period of increasing share price; it is designed to protect profits rather than increase returns.

F loor

Floors are similar to caps in that they consist of a series of European interest put options (called caplets) with a particular interest rate, each of which expire on the date the floating loan rate will be reset. In an interest rate floor, the seller agrees to compensate the buyer for a rate falling below the specified rate during the contract period. A collar is a combination of a long (short) cap and short (long) floor, struck at different rates. The difference occurs in that on each date the writer pays the holder if the reference rate drops below the floor. Lenders often use this method to hedge against falling interest rates.

Caps

An interest rate cap is actually a series of European interest call options (called caplets), with a particular interest rate, each of which expire on the date the floating loan rate will be reset. At each interest payment date the holder decides whether to exercise or let that particular option expire. In an interest rate cap, the seller agrees to compensate the buyer for the amount by which an underlying short-term rate exceeds a specified rate on a series of dates during the life of the contract. Interest rate caps are used often by borrowers in order to hedge against floating rate risk.