What Is a Fraption?
A fraption is a type of option that gives the holder the opportunity to enter into a forward rate agreement (FRA) with predetermined conditions and within a certain amount of time. Forward rate agreements are contracts to exchange a pre-determine interest rate to be paid on a future date on some notional amount. Because of this, a fraption is also known as an "interest rate guarantee."
Like vanilla options, fraptions have an expiry date. Buyers use fraptions to protect against interest rate changes at the cost of a premium before that contract expires.
- A fraption is the right but not the obligation to enter into a forward rate agreement (FRA) at some point in the future, effectively establishing an interest rate guarantee.
- Fraptions are drafted over-the-counter, making them highly customizable in terms of the notional amount of the FRA, rates, and relevant dates.
- Fraptions are used by corporations and institutions as a cost-effective way to manage interest rate risk.
How Fraptions Work
Fraptions give the holder the right to enter into a forward rate agreement if they so choose. Like vanilla options, a fraption offers rights but is not an obligation to the buyer.
The buyer pays a premium for the fraption in order to lock in the interest rate. If the fraption is not exercised (turned into a forward rate agreement) because interest rates remain relatively stable or even drop, the buyer loses the premium but is not obligated to enter into the forward rate agreement.
If the buyer chooses to exercise the option, they will enter into the forward rate agreement per the terms of the fraption. Fraptions are only traded over-the-counter (OTC), allowing the two parties involved in the transaction to specify the exact terms they want. Terms include the notional amount of the forward, the expiry of the options portion of the fraption, the premium on the option, the settlement date, maturity date, and rates of the forward. If both parties agree, the fraption is created.
Once the forward rate agreement is in place, the options portion of the transaction ceases to exist. The seller of the fraption keeps the premium paid and the forward takes the option's place as an obligation to both parties.
Using a Fraption
Fraptions are primarily used by corporations and institutions to manage interest rate risk. The buyer of the fraption and forward rate agreement typically wants to protect against a rise in interest rates. Thus, the buyer of the forward pays a fixed interest rate on a notional amount of money.
Meanwhile, the seller of the fraption and the forward rate agreement wants to protect against a decline in interest rates. The seller pays a floating interest rate, typically linked to LIBOR.
The notional amount of the forward, say $1 million, is not exchanged between the two parties. Rather, only the monetary difference created by the two interest rates is exchanged on the effective date of the forward.
Because forward rate agreements don't require an exchange of the notional amount between the two parties, they are considered "off-balance-sheet" agreements, meaning the corporations don't need to report the agreement on their balance sheet.