Which of the following is equivalent to a receive-fixed swap with a tenor of one and a half years with semi-annual swap payments and a fixed rate of 5% (exchanged for London Interbank Offered Rate (LIBOR))? Assume that the notional principal is $10,000,000. A) A forward rate agreement, which obligates the party to receive a fixed rate of 5% and pay six-month LIBOR on a notional principal of $10,000,000. B) A strip of three forward rate agreements, which obligates the party to receive a fixed rate of 5% and pay six-month LIBOR on a notional principal of $10,000,000. C) A strip of two forward rate agreements, which obligates the party to receive a fixed rate of 5% and pay six-month LIBOR on a notional principal of $10,000,000.
C 2 not 3
bpdulog Wrote: ------------------------------------------------------- > C What is the rationale behind it being C?
Schweser question. C is correct - 2 strips of FRA I can never understand the answer though. enter into one FRA strip now. payment determined in 6 months and made in 12 months? enter into the next FRA in 6 months, payment determined at 1 year and then made 1.5 years? Where is the payment at 6 months though? the swap will pay in 6 months, but the FRA wont…???
swap paying in 6 months is based on current LIBOR - so it is known in advance… (when you enter into the swap). You price the fixed side, you know today’s LIBOR - so you know what payment is due in 6 months time (remember the PAY IN ARREARS part)
actually the answer depends if the LIBOR for the first interest period is already fixed or not. If not, I say close 3 FRAs (0x6 first one, the question is if anyone would quote it) We could also argue that there is no information when the swap starts, … but obviously the answer is C, the cash flows will not match, the value will not match, they have equivalent interest rate risk (more or less)
^^^ CPK - I understand where the 6 month payment on the SWAP comes from, but how is the equivalent an FRA. Won’t a 6 month LIBOR FRA payment be determined in 6 months, but not made until 1 year??
actually FRA 6x12 will be determined and settled in 6M (the interest difference will be discounted) the cash flows will not match see my post above for the rest
^^ thanks! FRAs and swaps kill me.