An option on a forward rate agreement that gives the holder the right, without the obligation, to buy an FRA at a predetermined strike during a set period of time. It gives the holder protection against adverse rate movements, i.e., falls in interest rates, by owning the right to stick to a fixed rate for a future period.
For example, if a portfolio manager has $50,000 in cash assets, and would like to guarantee a 9% annual minimum return on the portfolio’s cash component. He may buy an interest rate guarantee for 9% against a premium. If interest rates decrease over the course of the next year to 6%, the investor can exercise the option, receiving the difference between the two rates: 9%-6%= 3%.
The interest rate guarantee is alternatively known as a fraption.
