Page 143 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes 7. Eurodollar futures work the same as T-bill contracts except the rate is based on …………….
8. Eurodollar futures are settled in …………..
9. The day count for futures contracts is actual days over a ……….. day year.

10.3 Forward Rate Agreement

A Forward Rate Agreement (FRA) is a widely used financial derivative by various participants
in the money and securities market to manage interest rate risk. In recent years, FRA has become
a very useful hedging instrument to manage interest rate risk in a deregulated interest rate
environment. A FRA is a forward contract between two parties to exchange interest payments
for a notional principal amount for a specified future period. On the settlement date, the parties
to a FRA agree to exchange interest payments. Banks, all-India financial institutions, primary
dealers are allowed to undertake FRA and can also offer these products to corporate and mutual
funds for hedging their balance sheet exposures. To undertake FRA, no specific permission is
required from the RBI.

The various elements of a FRA are:
1. Notional principal
2. Fixed rate

3. Floating rate
4. Tenor
5. Payment dates and Connections
6. Documentation
The prudential and accounting norms which have been issued by the RBI with reference to FRA
are as mentioned below:
1. A sound internal control system should be set up by the participants that should provide
for a clear functional separation of front and back offices relating to hedging and market
making activities.

2. Banks, Financial institutions, primary dealers and corporates are required to maintain
capital for FRA transaction, according to the guidelines issued by the RBI.
3. Transactions relating to hedging and market making activities need to be recorded
separately. For valuation purposes, the respective boards should lay down an appropriate
policy to reflect the fair value of the outstanding contracts.
4. The FRA position undertaken by banks, financial institutions and primary dealers should
be within the prudential limits, as identified in each maturity bucket and should also have
the approval of their respective boards.
Self Assessment

Fill in the blanks:
10. A FRA is a forward contract between two parties to exchange interest payments for a
…………. amount for a specified future period.

11. On the settlement date, the parties to a FRA agree to exchange …………. payments.

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