Context:
State-owned Life Insurance Corporation of India (LIC) has officially entered the bond Forward Rate Agreements (FRAs) market through transactions with over 10 major banks, both domestic and foreign, marking a strategic move to manage interest rate risks associated with its portfolio.
Why This Move Matters?
- Purpose: To hedge against interest rate volatility, particularly for its growing share of non-participating (non-par) insurance products, which require stable long-term returns.
- Impact: Expected to increase demand for long-term government securities (30 years+), but may narrow forward spreads, affecting profitability of smaller market players.
Forward Rate Agreements (FRA)
A Forward Rate Agreement (FRA) is a financial contract between two parties to lock in an interest rate for a specified future period on a notional principal amount. The contract settles in cash based on the difference between the agreed-upon forward rate and the actual market interest rate on the settlement date.
Purpose
- FRAs are primarily used by institutions like banks and insurers to hedge against fluctuations in interest rates.
- By fixing a rate in advance, they manage the risk of rates rising or falling in the future, which impacts borrowing costs or investment returns.
Difference Between FRAs and Bond Forwards
| Aspect | Forward Rate Agreements (FRAs) | Bond Forwards |
|---|---|---|
| Nature of Contract | Agreement to lock in an interest rate on a notional amount for a future period. | Agreement to buy/sell a specific bond at a predetermined price on a future date. |
| Settlement | Settled in cash based on the difference between agreed rate and market rate. | Physical delivery of the bond at contract maturity (no cash settlement). |
| Underlying Asset | Interest rates (no actual bond or loan is exchanged). | Specific government bond or security. |
| Risk Mitigation | Hedge interest rate fluctuations without bond ownership. | Hedge interest rate risk with actual bond delivery, reducing procurement risk. |
| Market Usage | Commonly used by banks, insurers to hedge interest rate risk on liabilities or assets. | Used by insurers and investors to lock in bond prices and ensure delivery. |
| Settlement Risk | Requires sourcing bonds at settlement for hedging if needed, adding market risk. | Eliminates settlement risk as bond delivery is contractually guaranteed. |
| Regulatory Status in India | Allowed and widely used for interest rate risk management. | Recently permitted by RBI and IRDAI, expanding hedging tools. |
