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An interest rate agreement is a type of financial contract that commits the buyer to tendering some type of compensation to the seller if and when the interest rate identified in the terms of the agreement should vary from some type of predetermined figure or range of figures. Also known as an FRA or forward rate agreement, this type of contract usually includes a structure for tendering those payments according to the status of the rate at specific times throughout the duration of the agreement. An over-the-counter agreement of this type will involve the use of a floating or variable interest rate as part of the agreement.
The structure of an interest rate agreement will involve the identification of what is known as the strike rate. This is simply the rate that serves as the standard for determining if there is the chance of interest becoming due to the seller. Along with the strike rate, the terms of the agreement will also define what is known as a reference rate. The reference rate is the variable interest rate that may rise or fall below the strike rate and possibly trigger the necessity of tendering some sort of interest payment to the seller.
In actual practice, the buyer must make some sort of payment to the seller if the reference rate should exceed the strike rate at specific points during the life of the interest rate agreement. Each time that the reference rate is found to be above the strike rate at or near one of these designated time frames, a payment to the seller becomes due, based on just how much that reference rate exceeds the strike rate. The process continues until the contract reaches its maturity date, at which point the two parties may choose to renew the arrangement or move on to other investment opportunities.
The idea behind an interest rate agreement is to allow both parties the potential to earn some sort of return from the transaction. The buyer stands to earn more of a return if the reference rate remains below the strike rate, since this means that no payments are due to the seller. At the same time, the seller will often offer the asset to the buyer at a discounted purchase price, projecting that the strike rate will rise above the reference rate repeatedly during the life of the agreement, making it possible to receive returns that offset the discount and provide a little extra income. Both parties do take on some degree of risk that the deal will not work in their favor, making it necessary for both buyer and seller to project the outcome of entering into the interest rate agreement and determining if the risk level is worth the potential returns.
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