P1.T3. Interest rate Cap Vs FRA

Sha

New Member
Hi .. Am getting more confused with exam approaching. How does an Forward rate agreement differ from interest rate cap. Could you please explain?
 

David Harper CFA FRM

David Harper CFA FRM
Subscriber
Hi Sha,

It's analogous to the difference between an option (which incurs an initial cost--aka, premium--and might be purchased for insurance) and a forward (which has no initial cost due the symmetrical payoff; and might be used to hedge): the FRA can produce a positive or negative payoff = t*notional*(rate - K), where K is the fixed "strike" rate. The caplet, as an interest rate option, produces a non-zero payoff = t*notional*MAX(rate-K); the cap is a sequent of caplets, so would be analogous to a series of FRA (and a series/portfolio of FRAs is effectively an interest rate swap). Thanks,
 
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