Forward Rate Agreements and Swaps
But over shorter periods, the curve can steepen and flatten, right?
1 thought on “Forward Rate Agreements and Swaps”
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Are you trader material? What are swap rates? Swap rates are the interest rate differentials embedded in currency trades. Now that it is clear, it seems silly.
An FRA, just like a deposit, involves two cash flows. We pay the counterparty a notional at time , and receive our notional plus interest of at time ; where the first term is the Year Fraction, the second is the Forward Rate, and the final is the Notional.
Since f will be fixed when we sign the contract, we can hedge these two cash flows exactly at using ZCBs. The value of the FRA is the value of receiving the second sum minus the cost of making the first payment:. Note that the price of all FRAs is uniquely determined from the discount curve [although in reality our discount curve will be limited in both temporal resolution and maximum date by the ZCBs or other products available on the market which we can use to build it].
A Swap is an agreement to exchange two cash flows coming from assets, but not the assets themselves. By far the most common is the Interest Rate Swap, in which two parties agree to swap a stream of fixed rate interest rate payments on a notional M of cash for a stream of floating rate payments on the same notional.
Although the notional might be quite large, usually only the differences between the payments at each time are exchanged, so the actual payments will be very much smaller. The mechanics are probably best demonstrated by example:. What payments actually get made?
At this time, the fixed payment will be. The same calculation happens at each time, and a payment is made equal to the difference between the fixed and the floating leg cash flow.
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