A forward spread agreement is a term used in the financial industry, particularly in the fixed income market. It is a contract between two parties, where one party agrees to buy or sell a security at an agreed-upon price in the future, and the other party agrees to pay a spread over a benchmark rate.
The spread is the difference between the price of the security and the benchmark rate, which reflects the creditworthiness and liquidity of the security. The benchmark rate can be a government bond yield, LIBOR, or any other widely accepted rate.
Forward spread agreements are often used by investors and traders to hedge their exposure to price and interest rate fluctuations. For example, a bond investor may enter into a forward spread agreement to sell their bond at a future date to lock in a desired yield. On the other hand, a trader may enter into a forward spread agreement to speculate on the future direction of interest rates or credit spreads.
In addition to hedging and speculation, forward spread agreements can also be used for financing purposes. For instance, a company may use a forward spread agreement to raise funds by selling a future stream of cash flows from their assets or liabilities.
It is important to note that forward spread agreements are typically customized contracts negotiated between two parties. They are not standardized like exchange-traded futures or options. As such, they involve counterparty risk, meaning that one party may fail to fulfill its obligations under the agreement.
Forward spread agreements can be complex financial instruments, and it is recommended that investors and traders seek the advice of a qualified professional before entering into such contracts. Proper risk management strategies should also be in place to mitigate potential losses.
In summary, a forward spread agreement is a contract between two parties that allows one party to buy or sell a security at an agreed-upon price in the future, while the other party pays a spread over a benchmark rate. It is commonly used for hedging, speculation, and financing purposes but involves counterparty risk and requires proper risk management.