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Usages of Forward Rate Contracts

Forward rates are break-even rates for making long/short lending/borrowing decisions. This resolves the issue of choosing between lending once for two years or lending twice for one year. The choice has to do with perceived spot rates at the 1-year horizon. If perceptions are such that the spot rate will be below the forward rate, the choice would be to lend at forward rates. If the spot 1-year rate in one year is believed to be above the forward rate, the correct choice is to lend twice for 1 year.

The forward rates serve a number of purposes:

• they are the break-even rates for comparing expectations with market rates

• it is possible to effectively lock in forward rate for a future period as of today

• they provide lending/borrowing opportunities rather than simply lending/borrowing cash at the current spot rates.

Forward rates offer new lending and borrowing opportunities. Upward sloping curves might offer attractive forward investment opportunities, and downward sloping curves might offer attractive forward borrowing opportunities.

In general, practical decisions have to be made for future funding or investing excess cash. One of the pre-requisites for ALM is to determine what would be such deficits or excesses of funds in the future. It will be explained in the ALM section (Section 7) that raising money too early is not economical. Conversely, investing today excess cash that will exist only in the future is not feasible, because no cash transaction is feasible today. But once such excesses or deficits are projected with a reasonable accuracy, a decision has to be made: Hedging or not? Forward rates are benchmark rates to which one should compare the perception of future spot rates for making a decision.

This rule is general. For making a hedging decision, it is necessary to find the break-even point, here a break-even interest rate prevailing at a future date and unknown as of today, making hedging and no-hedging equivalent in terms of final pay-off. In the case of a forward contract, the break-even rate is equal to the forward rate. The next step is to compare expectations, when there is some consensus, to the break-even rate.

If interest rates for 1-year are expected to be above the 7.0095%, the no-hedge choice (waiting) would be the best. For the previous example, when the choice was to lend once or twice over a shorter period than horizon, it would be better to roll-over the loan twice for 1 -year. If there are future excesses of cash to be invested, the decisions would be no hedging, or equivalently, doing nothing. If there is a consensus on a decline of interest rates below the break-even value, the forward hedge is the best solution. In the lend-long versus lend-short decision, hedging would mean lending straight for 2 years. In the case of excess cash forecasted in the future, the hedging decision would be to use a forward contract starting when the excess cash is available and ending at some horizon. There is a last scenario, which is the "myopic" scenario, when there is no consensus on any trend. Then, using forward contracts is a common practice, even though there is a chance that the forward ends up losing because the future spot rates are higher in the end.

Note that this presentation is simplified. It assumes implicitly that the amount of excess cash is constant between the initial and the final dates. This is not the case in practice and several contracts are needed to hedge various amounts matching the time profile of excess cash over different periods. Examples of hedging programs will be provided in the ALM chapter (Chapter 24).

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