I guess it made me feel a little better when I heard this, along with pension accounting are the toughest parts of the exam.
Can someone please explain some simple items?
A long interest rate call + a short interest rate put = FRA.
For a long interest rate call, you pay fixed and receive floating. This is triggered when itnereest rates rise. Can someone please explain why this would be pay fixed and receive floating?
Also, a long interest rate put is pay floating and receive fixed. So a short interest rate put = pay fixed, receive floating, which is the same as a long interest rate call.
Does the fix mean a premium? Since you have the option?
If you are long an interest rate call, lets say at 6%, your payoff will be based on the current market interest rate. You can exercise your right to pay 6%, but you’ll only receive what the current market rate is at the time of exercising. Therefore you’re locked into paying a gaurenteed fixed 6% interest but once you exercise the call you will receive whatever is currently the market rate.
If C > M, exercise call and pay a rate below market. If C < M, do nothing
If you are long an interest rate put , lets say at 6%, your payoff will be based on the rate you sold at, which is 6%. When you exercise your 6% put, you sell the rights to the fixed 6% interest rate and receive whatever is the current market rate at the time of exercising.
If P > M, do nothing, if P < M, exercise Put and receive a rate below market rates.