Forward Rate Agreement (FRA) and Option Contract

FRA is the OTC derivatives that allow banks to take a position on the forward interest rates.
- The contract gives the right to borrow / lend funds at a fixed rate for a certain period begins at a later date.
- No exchange or the principal amount
- The maturity of the cash settlement is the difference between the rate of the contract with the LIBOR rate prevailing at the time.
FRA is the OTC version of the interest rate futures contracts and more flexible than the future. FRA raises interest rate risk

Option Contract
- Providing the right (but not the obligation) to customers to make transactions under the contracts at the agreed price → means that the transaction will not be executed if the rate is not attractive to the customer / buyer.
- The seller has the open-ended risk of the contract and receive a premium as compensation.
- Option can be made of all cash and derivative instruments, there is even the option to option.
- The main term to describe the option is:
o Call - a call option gives the buyer the right to buy the underlying instrument
o Put - put option gives the buyer the right to sell the underlying instrument
o Premium - the amount paid to the seller by the buyer
o Strike Price - the price where the transaction will be done
o Exercise - run the option buyer to enter into a contract
o Expiry date - last date which the option must be done
o American - option that can be done on every day until the due date
o European - that option can only be done on the due date
- Determination of option pricing is based on the possibility of the option is implemented. To calculate the value of the option, use the calculation of volatility. Volatility of prices is that market prices reflect market expectations of how much prices will move in both directions during the option period.
- Option risks inherent in the instrument basically happens when the option is. Option also has a volatility risk and interest rate risk because the date of execution occur in the future. Example: option on a bond have the same risk as the risk of bonds and the risk of changes in the volatility of the oblogasi.