IAre principle amounts always included in the calculation of the value of FRA's? In the solution to q3.6 in the Q&A banks the principal amount is included. Value = (- discounted value principle lent at start) + (discounted value of principle plus interest received at end) Also the formula given in notes doesn't work: Value of FRA = L(Rk - Rx)(T2-T1)e(-R2T2) Does this only apply at outset? Is it only interest rate swaps that don't include principal amounts? Thanks
Although the principle is not exchanged in a interest rate swap it effectively is, it's just that it would be the same for both parties, so no cash is actually exchanged. FRAs are actually cash settled in advance At t1 with the value of the agreement. This amount is the discount value of the difference between the current cost and the agreed rate at the outset on the notional. Both fras and swaps can be priced assuming the principle is exchanged, as this makes no difference to the maths.
This formula always applies. Out outset an fra hass zero value with rk equalling rx. This formula comes from hull. The r rates are t2-t1 compounded rates and the r2 is a force of interest. Does that help?
