A fraption is a type of financial option that allows its holder the possibility (but not the obligation) to sign a forward contract on an interest rate, at a strike price and a time period determined in advance. It is also sometimes known as a fraption in Spanish.

The acronym fraption in English comes from the combination of the words forward rate agreement (agreement on future interest rate) and the word option (option). Using this derivative instrument, an investor, entrepreneur or individual can hedge against unexpected fluctuations in interest rates.

Interest rates fluctuate in the markets and these can hurt or benefit investors (depending on the direction in which they move). Therefore, a fraption could be considered as an insurance that will cover the investor in case the interest rate plays against him and his investment does not bring him the expected return.

Characteristics of a fraption

Based on the nature and operation of this derivative instrument, we can highlight some of its main characteristics:

  • It is a derivative instrument intended to hedge risks.
  • It allows transferring the risk of the operation to the counterparty with whom the fraption is contracted.
  • It allows us (in exchange for paying a premium) to obtain the expected or required return on an investment.
  • It allows the investor (not exercising the fraption) to benefit if the interest goes in his favor and the profitability obtained exceeds the expected profitability.

Example of an operation with a Fraption

Let's imagine, for example, that a private investor owns € 100,000 and would like to obtain a 10% return through a 1-year fixed-term deposit. This investor could (by paying a premium) subscribe a fraption with which he would make sure to obtain that 10%.

If at the expiration of the deposit the interest rate was situated at 5% (lower than the expected profitability), the investor could exercise the fraptión. In this way, the counterparty with whom the fraption was subscribed would have the obligation to pay us the remaining return up to that 10% (in this case, 5% on the deposit).

On the other hand, if the interest rate reaches 15% (exceeding the expected profitability) the investor could not exercise his option to fra and obtain that 15% profitability. The money paid for the premium to subscribe the fraption would be lost, but most likely the profitability obtained would exceed the payment of that premium.

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