When rates go down, the price of futures will go up, say, to 97. Of course, the borrower would not buy at 97 and would then exercise the option of selling at 95, so that the option is cancelled and the business will simply benefit from the lower interest rate. Risks arise for businesses if they do not know what will happen in the future, so it is clear that many business decisions and activities involve risks. 6. Analysis of interest rate swaps and currency swaps 6.1. The risks associated with swaps 6.2. Benefits of a Business in the Swap Market The most common type of swap is to exchange fixed interest payments for variable interest payments on the same nominal amount. This is called a simple vanilla swap. The interest rate derivatives under discussion are: 9 Short-term interest rate risks can be covered by a short-term interest rate agreement, short-term interest rate futures and borrowers and interest rate option lenders. Forward Rate Agreement is a futures contract in which the buyer of the FRA agrees to pay a fixed interest rate for the fictitious loan and, in return, to receive interest at the current market rate; and the seller agrees to collect interest on the amount at a fixed rate and to pay interest at the current market rate. FRAs have the advantages of being tailored to a customer`s specific requirements and do not involve payment before or billing date. However, FRAs are more expensive than futures with comparable interest rates and cannot be resold on a secondary market.
Short-term interest rate futures (STIRs) are standardized futures contracts traded on a fictitious deposit equal to a standard amount of capital, effective from the final settlement date of the contract. AMPs are purchased or sold in such a way that if the underlying cash price moves in an unfavourable direction, there will be a profit on the future position that will more than offset the loss in the cash market. STIRPs are more liquid, but they are only available in standardized size and include prepayment of a margin.