forward_rate_agreement.pdf - Forward rate Agreement(OTC...

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Forward rate Agreement (OTC Derivative) CA. Nagendra Sah Page 1 OTC Derivative: OTC (Over-the-counter) contract is a contract which is privately negotiated between two parities. OTC derivative is a derivative which is not traded on an exchange and it is being traded over-the- counter (i.e. privately negotiated) . Derivative are traded in two kinds of market: (i) Exchange (ii) OTC Market OTC Market Vs Exchange OTC market is an informal market consisting of dealers or market makers who privately negotiate transactions over electronic communication networks. Example of OTC market in India: OTCEI (Over the counter exchange of India) It is an electronic stock exchange based in India and it has no central place of exchange (i.e. no trading house) and all the trading is done through electronic network. Example of OTC market abroad: NASDAQ (National Association of Securities Dealers Automated Quotation System) Exchange means Stock exchange. Stock exchange has been defined in the SCRA 1956 (For more discussion on stock exchange see theory of chapter-Indian capital market. Future contract traded OTC is a forward contract and the Forward contract traded in an exchange is a future contract. However, Option traded in exchange or traded OTC both is called Option. In exchange trading, clearing houses guarantees the contract performance. However, in OTC market there exist risks of default because contracts are privately negotiated. OTC derivative Forward contract: For discussion on forward contract see FOREX and derivative contract. For Understanding forward rate agreement first we have to understand forward interest rate or Implied Forward rate (Calculation of forward rate is based on expectation theory) . Implied Forward Interest rate: [M-10-New-8 M] [N-08-New-4 M] [RTP- N-09-New] Forward interest rate is the interest rate (It is different from the forward exchange rate which we studied in FOREX) that we expect to prevail in the market after certain period. For calculation of implied (i.e. Fair) forward rate, first know some terms which are discussed below: Meaning of 1st year Forward rate (Also known as 1 Year forward rate as of today) It is an interest rate that we expect at beginning of 1 st year for the borrowing/deposit made for 1 year period. Today 1 Year Borrowing/deposit period Expected interest Rate as on today for this Fo rward Rate agreement Interest rate swap Caps, floor and Collar Forward Contract
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Summary of OTC derivatives CA. Nagendra Sah Page 2 Meaning of 2nd year Forward rate (Also known as 1 Year forward rate 1 year from Now) It is an interest rate that we expect to prevail at beginning of 2 nd year for the borrowing/deposit to be made for 1 year period after 1 year time. Today 1 Year 2 Year Borrowing/deposit period Expected interest rate at 1 year time for this Meaning of 6 month Forward rate 3 month from now (Also known as 6 month forward rate 3 month forward) It is an interest rate that we expect to prevail at 3 month time for the borrowing/deposit to be made for 6 month period after 3 month time.
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