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 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) A forward rate agreement, which obligates the party to pay a fixed rate of 5% and receive six-month LIBOR on a notional principal of $10,000,000. D) 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.
D?
D?
^^^haha
lol NIB … you are tooo fast!
We all got trapped. ******************************** Your answer: D was incorrect. The correct answer was B) 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.
Someone care to elaborate a little more than schewser’s answer?
Nib…do you understand this?
Not really, I was hoping someone else would chime in to explain.
whatta heck, D is not the correct ans?? Can anyone explain why they chose 2 strips over the very obvious 3 ones?
Dinesh here is my guess: At the inception of the swap the first periods floating rate is already known, while the fixed payments are know for the life of the swap. So you really only have two FRAs which would determine the floating rates for the next two payments. Not sure this thinking is correct though.
you are correct, mwvt9. the first payment is known, two more forward rates are still needed -> B
Correct mwvt9 & maratikus!! That was a good one.
Wouldn’t the semi-annual swap make 3 payments (at 6, 12, and 18 months)? So you would need 3 FRAs to replicate this? What am I missing?
The first floating rate is known at inception of the swap, so you only need two more FORWARD rates (FRAs) to replicate the swap. That is what we were saying above anyway. I am still not comfortable with the answer though.
By 1.5 year tenure I assumed tenure for the swap’s life, not necessarily starting at the present. Meaning a 1.5 tenure could be 1.5 years starting in .5 years.
“tenor” Swan.
BTW - The asnwer to this is above. A swap starting aat some future date is a forward swap and not what they are talking about. Anyway, a swap with “term” = x years (much more common terminology than “tenor” in my experience) which pays 2 times per year has only 2x - 1 unknown payments that need to be hedged.
Joey - If I understand that correctly we have 2*1.5 - 1 = 2 unknown payments to be hedged and hence the answer is B?
Yes.