I know how to calculate FRA payoffs but when they use the “2 by 5 FRA”/ “3 by 6 FRA” terminology, I’m totally lost and the answer explanations to questions don’t explain it very well – Can someone explain where this comes from please?
Also, apart from Interest Rate Swaps having a series of settlement dates, are there any other major differences between FRAs and IRSs?
Thanks in advance!!
Good luck for the exam everyone 🙂
So with a 2 by 5 FRA, all it means is that the contract expires in 2 months time, BUT the UNDERLYING asset (i.e. the loan) will start in 2 months and ends in 5 months (both are from now).
In algebraic terms, a n by m FRA is the contract expires in n months time, but the underlying asset will start in n months and ends in m months with the duration of m-n months.
As for the difference between FRAs and IRSs, with the FRA you agree to pay a fixed rate, but for an IRS you either pay a fixed rate AND receive a float rate (or vice versa), on top of the settlement date differences.
does that make sense @eprak22?
Also to answer your second question. In FRA the pay off is discounted whereas in an interest rate swap the pay off is not discounted. If you look at the FRA pay off formula you will understand.
Invariably, since the FRA pay off is discounted its pay off is lower than the pay off on an equivalent interest rate swap. Don’t ask me why the FRA is discounted because idk and idc.
Yea so I was going through derivative again and realized it’s discounted because the payment is made after contract expiration. Like for a 2 by 5 FRA the contract will expire after 2 months but payment will be made at the end of the 5th month. So you have to discount the pay off for the 3 months after expiration. #LeaveNoStoneUnturned lol
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