Hi, In controlling direct exposure to interest rate risk, is there a difference between FRA and Swaps? I see they both based on fixed and floating rate applied to either principal or notional amount. what makes the arrangement different? Thanks.
Hi. they are similar and can be used in a similar way to manage interest rate risk - but they are different. Both OTC (so, counterparty risk) can be used to lock into a fixed rate of interest in the future can be used for speculation But FRAs are a one-off (eg a fixed rate for one-year period starting in 2 years), a swap is a series of payments (eg fixed for floating annually for 5 years starting in 2 years) - a series of FRAs could be constructed to broadly replicate a swap timings of cashflows are different - FRAs settle at the beginning of the forward period, swap cashflows at the end of each period the FRA payoff is a single net cashflow from one party to the other; the swap has 2 cashflows (eg one fixed, one floating) - these will be netted off if in the same currency there are a wide variety of swaps based on all sorts of underlying - FRAs just based on interest rates In an exam - if you were discussing managing interest rates then you could gain marks by considering both! I hope this helps.
There are quite different. FRA has only one cash flow while swap has many. Also FRA is settled in arrear but swap is not. The paper provides you a lot more details. http://www.finpricing.com/lib/IrFra.html
Hi @Simon James Silly question, but grateful if you could please confirm whether our understanding aligns: Payment frequency: Swaps: Multiple FRAs: Single Payment Arrangements: Swaps: One counterparty pays the fixed leg to the other while the other one pays the floating leg continuously. FRAs: Same arrangement as above, however instead of continuous payment a net cashflow arrangement will be paid off at one point in time. Payment Timing: Swaps: Settled in arrears. FRAs: Settled upfront. Thanks