Explanation

Let's analyze each option:

A. The underlying is a currency exchange rate.

• Incorrect. A Forward Rate Agreement (FRA) is an interest rate derivative, not a currency derivative. The underlying is an interest rate (typically LIBOR or another reference rate), not a currency exchange rate.

B. The short position hedges against an increase in interest rates.

• Incorrect. In an FRA:
  • The long position (buyer) hedges against an increase in interest rates (receives payment if rates rise)
  • The short position (seller) hedges against a decrease in interest rates (pays if rates rise)
  • So the short position actually benefits from falling interest rates and hedges against declining rates.

C. The contract is closely tied to the term structure of interest rates.

• Correct. FRAs are directly linked to the term structure of interest rates because:
  1. They reference forward interest rates
  2. Their pricing is based on the relationship between spot rates and forward rates
  3. They represent agreements on future interest rates, which are derived from the current yield curve
  4. The forward rate is calculated from spot rates using the formula: $(1 + S_2)^{t_2} = (1 + S_1)^{t_1} \times (1 + F_{1,2})^{t_2 - t_1}$ where $S_1$ and $S_2$ are spot rates, and $F_{1,2}$ is the forward rate

Additional Context:

• An FRA is an over-the-counter (OTC) contract between two parties to exchange payments based on a specified notional principal amount
• One party pays a fixed interest rate, while the other pays a floating interest rate
• Settlement occurs at the beginning of the reference period, with the payment being the present value of the interest rate differential
• FRAs are used by banks, corporations, and investors to hedge against or speculate on future interest rate movements