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A following statements refer to interest rate risk. Are each of the following statements
Statement 1: The aim of a forward rate agreement (FRA) is to lock the company into a target interest rate and hedge both adverse and favourable interest rate movements.
Statement 2: An interest rate guarantees (IRG) is more expensive than an FRA as one has to pay for the flexibility to be able to take advantage of favourable interest rate
Statement 1 & 2 are true.
Sir can you explain statement 1? FRA will lead to gain if adverse rates in future or loss if favorable rates in future. We cannot step back if situation is favorable and we do not want to opt like in Option. So why it is saying that is is used to hedge both favorable and adverse interest rate movement.With a forward rate agreement the interest rate is fixed regardless of what happens to the actual interest rate.
The actual interest rate might end up better or worse for us than it currently is (and this is why there is risk) but using a forward rate means that the risk is removed and we are guaranteed a fixed rate.
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