I kind of understand the answer but where is the payment after the sixth month come from? 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 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. B) 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. C) 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. Your answer: B was incorrect. The correct answer was A) 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. This is an example of two 6-month forward rate agreements (FRAs). The first FRA is entered into at time 0 with the payment determined at 6 months and paid at 12 months. The second FRA is entered into at 6 months with the payment determined at 12 months and paid at 18 months.
Swaps pay in arrears. So the rate for settlement at t=2 is determined at t=1. Your first payment at the first settlement date is know at the intimation of the swap. Therefore the number of FRA needed is = settlements -1. Reread the explanation below with the above in mind: This is an example of two 6-month forward rate agreements (FRAs). The first FRA is entered into at time 0 with the payment determined at 6 months and paid at 12 months. The second FRA is entered into at 6 months with the payment determined at 12 months and paid at 18 months.
I had wondered about this answer to-I thought it was c). Dont you get 3 payments with a swap though, payment at in 6months, 12months and 18months?
At the day you enter the swap (today) you know that you are going to have to make a payment in 6 months, but (here is the important part) the payment you make in six months is based on TODAY’s libor. So in the example above, since there are only three payments, and you already know what the first payment will be (because you already know today’s LIBOR), you only need two FRAs. or Number of settlement payments - 1