FRA and swap terminoligy

[wrongsaidfred]

Hi David,

For certain instruments, like an FRA or swap, do the terms long and short necessarily mean anything? If someone is long an FRA, does this mean that they are locking in a rate they are paying at or a rate they will be paid at? Same idea for a swap. Does long mean they are fixed payer or floating payer?

Also, do FRAs still use the 2 x 5 notation or is there something else we should expect to see?

Thanks in advance for any guidance.

Mike

 

[David Harper CFA FRM]

Hi Mike,

As the long typically pays the fixed rate, I guess the long is the fixed-rate payer, floating receiver in an interest rate swap, but this never helps me and i do not perceive long/short as useful w.r.t. swaps because we can have fixed-for-fixed and floating-for-floating, so I totally avoid the use of long/short in the swap context. (and i would be shocked for FRM to reference swaps with long/short).

In the FRA, you buy the FRA (go long) by agreeing to pay the fixed rate; the seller (short) is receiving the fixed rate. I do think long/short makes more sense here.

The FRM, to my knowledge, does indeed employ (eg) 2 x 5 notation for FRA. And i think it is generally common to use (eg) FRA 3 x 6 to refer to contract expiring in 3 months on the 90-day LIBOR; i.e., given an n * m FRA, contract expires in n rate on an (m-n) month LIBOR.

Thanks, David

 

[wrongsaidfred]

Thank you! When you say "expire" does that just mean that is when the contract actually begins or "kicks in"?

Thanks again for your patience.

Mike

 

[David Harper CFA FRM]

Mike,

No, if the 90-day interest period in a FRA 3 * 6 runs from T1 (+90 days) to T2 (+180 days), then T1 is "maturity" or "delivery;" i.e, what is today (T0) a forward rate will be at T1 a 90-day spot rate.

In an FRA 3 * 6, the contract matures (i am using synonymously: expiration = maturity = delivery, but maybe "maturity" is best ...) in three months. At that point (t0 + 3 months), it references a 3-month spot rate (which is today a 3-month forward rate). This is analogous to Eurodollar futures contracts, where the "beginning of the interest rate period" is the delivery date for the contract (i.e., maturity).

We might think of delivery/maturity/expiration as the same as a consumption commodity, at T1, instead of settling corn, the seller settles with the updated 90-day LIBOR.

Thanks, David

 

[trabala38]

Hello David,

Well, working in the energy commodity business, I tend to say that "being long a swap" means that you pay the fixed leg. Why ? Imagine an fixed-for-floating oil swap. Because long means : if oil price goes up, the value of your swap increases. Thus, it means that you should receive the floating price and pay the fixed price, so that the delta is positive (in your favour).

To me, a fixed for floating interest swap is exactly the same (long = pay the fixed rate leg). The terminology long/short makes sense for those instruements.

However, I do agree with you for other swap instruments: the terminology does not make a lot of sense for fixed-for-fixed currency swap and floating-for-floating...

Regards,

trabala38

 

[wrongsaidfred]

Perfect.

Thank you.

Mike

 

[David Harper CFA FRM]

Trabala38,

Thank you! ... i was not aware of that long/short in energy but makes perfect sense, thanks, David

 

[David Harper CFA FRM]

Mike, Trabala:

I just noticed in the handbook (example 30.5) that GARP has a sample question "Identify the risks in a fixed-income arbitrage strategy that takes long positions in interest rate swaps hedged with short positions in Treasures."
... so, I stand corrected, GARP does employ "long" and "short" with respect to interest rate swaps

Thanks, David

 

[wrongsaidfred]

Hi David a quick question about forward rate notation. I can never remember what exactly 2f3 means as far as forward rates are concerned. I have been online for 20 minutes trying to find it on google and I nothing is coming up. Could you please let me know if this is a two year rate starting in 3 years or if it is something else?

Thanks,
Mike

 

[David Harper CFA FRM]

Hi Mike, I don't use that anymore but see http://www.bionicturtle.com/how-to/article/forward_rates_and_spot_rates/
e.g., 2f3 implies 2-year forward rate starting in 3 years (IMO) Thanks David

 

[wrongsaidfred]

Thank you!

Mike

 

[alexwallace]

@David Harper CFA FRM in the Financial Markets and Products textbook, Chapter 16 there is the following paragraph:

Could you please clarify why FRA holder is due 2,000$? If "holder" means one paying fixed, then he pays 10,000$ and receives 12,000$ - so word "due" here means holder (i.e. fixed payer) is expecting/supposed to receive $2,000? I was used to using word "due" when I owe something, not when somebody owes money to me? Probably, this is linguistic problem with me here?

And if my logic is indeed correct, than according to textbook, holder of the FRA (i.e. fixed payer) receives 1,976.28 after a year?


Thank You!

 

[David Harper CFA FRM]

@alexwallace I just answered you here about FRAs (https://forum.bionicturtle.com/thre...rward-rate-agreement-fra-hull.4510/post-87976 ) so I want to be brief: GARP's math here looks fine.

• The payoff (or payment) of $2,000 is based on +15 months = 12 months to settlement + 3 months "contract period". The contract period is 3 months because the reference rate is 3 month LIBOR: the 3-month LIBOR beginning in 12 months, which is a forward rate that we can express as F(1.0, 1.25).
• The payoff gets discounted to $1,976.28 the settlement date per the discounting formula. Some would refer to 15 months as maturity but but settlement is when the cash exchanges.

To your questions, while I agree with GARP's math, I disagree with its (lazy) language. "Holder" and "due" are ambiguous. Should be:

• Buyer/seller but more importantly it is clearly best in the case of confusing FRAs to specify who pays/receives the fixed ("srike" or "contract") rate
• They can avoid the "who is due" entirely by just saying that the contract's payoff is $2,000. To be honest, if i'm doing this question I just solve for the 1,976.28 before even wondering who gets it! Regardless of who is who, we're going to discount the payoff to the settlement. Then just figure out who's paying and who's getting ...
• The typical FRA settles in advance (i.e., at 12 months discounted from 15 here). If it the FRA is unusual and waits to 15 months, the the question would need to specify that the "FRA settles in arrears" because we don't expect that
• I'd add that I prefer "notional" to "principal" (although some do write "notional principal"). Unlike a bond, the $1.0 million is not principal, its notional that is referenced.

That's me being brief, no wonder i'm in the forum all day Sunday. I hope that's helpful,