Forward rate agreement vs Interest rate option

CFA Level II
#1

I can’t fathom what is the difference between the two?

#2

The primary difference is the same as the difference between a forward contract on a stock and a call or put option on that stock:

  • With the forward contract,
    • You are obligated to buy the stock if you’re the long
    • You are obligated to sell the stock if you’re the short
    • You don’t have to pay anything to enter into the contract
  • With a call option,
    • You are not obligated to buy the stock
    • You have to pay for the option
  • With a put option,
    • You are not obligated to sell the stock
    • You have to pay for the option

So it is with FRAs vs. interest rate options:

  • With the FRA,
    • You are obligated to pay the fixed rate and receive the floating rate if you’re the long
    • You are obligated to pay the floating rate and receive the fixed rate if you’re the short
    • You don’t have to pay anything to enter into the contract
  • With an interest rate call option,
    • You are not obligated to pay the fixed and receive the floating
    • You have to pay for the option
  • With an interest rate put option,
    • You are not obligated to pay the floating and receive the fixed
    • You have to pay for the option

The subtle difference is that the FRA is settled on the expiration date of the FRA, while an interest rate option is settled after the expiration (or exercise) date of the option (e.g., a call option on 6-month USD LIBOR would be settled 6 months after the option is exercised).

An FRA is equivalent to a pair of interest rate options: one long call and one short put, with the fixed rate on the FRA being the strike rate on the options.

#3

Dankeschön. Incidentally, did you not mean “one long call and one short put” instead of “one call and one short”?

#4

Bitteschön.

I did.

I fixed it.

Good eye.