In the example above, the loan involved only a single payment and, therefore, we had only one setting of an interest rate to worry about. Many loans are floating-rate loans, meaning that their rates are reset several times during the life of the loan. This resetting of the rate poses a series of risks for the borrower.
Suppose a corporation is taking out a two-year loan. The rate for the initial six months is set today. The rate will be reset in 6, 12, and 18 months. Because the current rate is already in place, there is nothing the corporation can do to mitigate that risk. It faces, however, the risk of rising interest rates over the remaining life of the loan, which would result in higher interest payments.
One way to control this risk is to enter into a series of FRA transactions with each component FRA tailored to expire on a date on which the rate will be reset. This strategy will not lock in the same fixed rate for each semiannual period, but different rates for each period will be locked in. Another alternative would be to use futures. For example, for a LIBOR-based loan, the Eurodollar futures contract would be appropriate. Nonetheless, the use of futures to manage this risk poses significant problems. One problem is that the Eurodollar futures contract has expirations only on specific days during the year. The Chicago Mercantile Exchange offers contract expirations on the current month, the next month, and a sequence of months following the pattern of March, June, September, and December. Thus, it is quite likely that no contracts would exist with expirations that align with the later payment reset dates. The Eurodollar futures contract expires on the second London business day before the third Wednesday of the month. This date might not be the exact day of the month on which the rate is reset. In addition, the Eurodollar futures contract is based only on the 90-day Eurodollar rate, whereas the loan rate is pegged to the 180-day rate. Although many dealer firms use the Eurodollar futures contract to manage the risk associated with their over-the-counter derivatives, they do so using sophisticated techniques that measure and balance the volatility of the futures contract to the volatility of their market positions. Moreover, they adjust their positions rapidly in response to market movements. Without that capability, borrowers who simply need to align their interest rate reset dates with the dates on which their derivatives expire can do so more easily with swaps. Nevertheless, an understanding of how FRAs are used will help with an understanding of this application of swaps.