- Instruments on over-the-counter (OTC) market
Several new instruments for covering interest rate risk have developed over the years on
OTC market. These instruments enable the operators to cover fixed as well as variable
rates.
- Fixed-Rate Instruments on OTC
Forward-Forward Operation
This is an operation that enables an operator to fix immediately interest rates of a debt or
a loan which will be contracted at a later date. For example, an enterprise wants to
ascertain today the interest rate on debt which it will borrow after 3 months for 6 months.
This can be done by:
- Borrowing for 9-months today;
- Lending for 3-months today.
These two sets of transactions will enable the operator to know in advance the effective
rate of interest on 6-months borrowing, 3-months hence from today, as desired.
- Forward Rate Agreement (FRA)
It is a kind of tailor-made futures contract. Unlike normal futures contracts which are
standardized, a forward rate agreement is for a predecided maturity date, for a predecided
amount, and at a predecided rate, as may be agreed between the borrower and lender.
The FRA may, prima facie, sound more attractive than futures. However, banks usually
charge a higher rate if an enterprise wants to borrow odd amounts for odd periods. And,
if the manager of the enterprise changes his mind and wants to sell his forward contract,
he must negotiate afresh with the bank.
- Interest Rate Options on the OTC Market
Options traded on the OTC market are generally similar to those traded on the organized
market. However, there are certain redeeming features of the OTC market vis-avis the
organized market. There is no financial asset in the case of an OTC option contract;
there is only an interest rate.
- They are not standardized: the amount and maturity are negotiated;
- Exercise price is the one defined in the contract;
- Premium is expressed in terms of percentage of the amount under option.