What is exactly settlement date in FRA. Let us say FRA for 5x8. I assuming that the meaning of it is it expires in 5 months and floating rate is rate at expiraton date for 180 day( 3 months) LIBOR. Is it correct? The formula used is notional principal (floating rate - forward rate)(days/360) / (1+ floating rate (days/360) Why is discounted by ( 1+ floatig rate (days/360) ? When is actual payment is done? Is it done after 5 months or after 8 months. Thanks, Chinni
Actual payment is done at the settlement date which in your example is after 5 months. It’s discounted so that an FRA is an exact hedge of a loan based on LIBOR in which interest would be paid at the end of the loan period. Since nobody wants to wait around for some known pay-off taking on counterparty risk, the FRA is settled by discounting the final pay-off amount.
JoeyDvire, That exactly makes sense. Now I know how FRA works. Appreciate for quick answer. Thanks, Chinni
will we know exactly when to discount the FRA? i’ve seen questions that don’t use the denominator to discount and the FRA is solved by: notional amt x (libor - FRA) (t/360). why do some have a denominator to discount and some don’t?
All real FRA’s have a denominator. Perhaps the question is asking you something that makes the discounting irrelevant (like you’re hedging something that gets discounted at the same rate)? Maybe you should post an example of this question.
slave, I think that you may be thinking about the equation for swaps?
Swaps are sort-of discounted to, except that they are paid in arrears instead of being discounted which amounts to the same thing.