Anyone understand the intuition behind:
When valuing a FRA before maturity of contract, we take the difference between the old FRA price calculated at inception and the new FRA price calculated at Time t.
I understand the methodology behind calculating this. However, I don’t understand it conceptually.
Anyone able to provide clarification on what is really going on behind these calculations?
If you can do it correctly but don’t know why, you have intuition.
If you know why, you have understanding.
The value of any derivative – or of any investment, for that matter – is the present value of what you will receive minus the present value of what you will pay.
In the case of an FRA (if you’re receiving the fixed payment), that’s the difference between the original fixed rate and the current (market) fixed rate, discounted back to today.
might be a dumb question. but why dont we value also the floating rate? why do the floating rate cancel out each other thus leaving us with only valuation of fixed rate. Thanks in advance for your reply.
Not a dumb question at all.
Remember that the fixed rate is the forward rate implied by yield curve. It, in and of itself, values the floating rate.
Suppose that you have a long position (paying fixed, receiving floating) in the original FRA. To get out of it, you take a short position in an FRA today, with the same expiration as the original, and the same loan period. (For example, the original was a 5×11 FRA, and it’s now 2 months later, so now you enter into an offsetting 3×9 FRA.) The floating rate will be the same: whatever the 6-month floating rate at expiration of the FRAs, so your net transaction is paying the original fixed rate and receiving the new fixed rate. The value is that difference discounted back to today.