A swap is equivalent to a series of:
A) interest rate calls.
B) FRAs priced at market rates.
C) off-market FRAs.
The correct answer is C with explanation Since the fixed rate on the swap is the same at every settlement date, a series of FRAs at those fixed rates will have values that differ from zero to the extent the fixed rate and the zero-value rate differ. This makes them off-market FRAs. Can somebody please explain me this concept in the explanation. Thanks in advance.
A market FRA will have a fixed rate equal to the implied forward rate for the loan period, and no money will change hands at inception. Unless the yield curve is flat, a series of market FRAs will each have a different fixed rate.
The series of FRAs that is equivalent to a (plain vanilla interest rate) swap will all have the same fixed rate. It will be higher than the market rate for some of the FRAs, and lower than the market rate for others. For any FRA for which that fixed rate is different from the market rate, money will change hands at inception; such an FRA is known as an off-market FRA.
Great explanation by @S2000magician.
Note that, most of the time, there won’t be any upfront payment when the Interest Rate Swap (IRS) is traded. Some of the FRAs have positive Present Values (PVs), some have negative PVs, and the fixed rate of the swap has been calculated so that the sum of the PVs of all the FRAs is zero. I.e. the IRS is at market, even though each individual FRA composing the swap is off market.
Bonus question – in what kind of situation might an IRS and all its underlying FRAs all be at market? (answer – when the rate curve is perfectly flat)