While discounting , how do we know when to use which discount factor r- Rate period - 60 days. i) 1/(1+{r*60/360} ) vs ii) 1/{(1+r)^(60/360) } I know in FRA we use i). Options (Lower Bound/Upper Bound) we use ii).
you would discount at the risk free rate for that tenor when the fra pays. For example, if you had a 2x4 fra, your payment would be calculated for the 4m time period which you would want to discount back to the 2m. you would use the rate between the 2m & 4m for this. Thus you would do 1+(rate*(60/360)) and divide by this #. (Are you looking at problem 105 on the BSAS morning exam by chance?) FRA’s will always be this way
No I am not looking at BSAS. I don’t even know what is it? I just want to know when do I need to use i) & when ii? in FRA - we are discounting back 60 days, we simple change the rate. in Options - we are discounting the strike price & we discount it using compounding. Why?