Notes

November 12, 2016

1 F ORWARD R ATE A GREEMENT

A FRA is an agreement to exchange a fixed rate for a floating rate. This contract has value equal
to zero at inception by no arbitrage. Thus, we can write

F R A(t , T, S, N , K ) = N τ (K − L(T, S)) P (t , S)

By definition of LIBOR rate, we have

³ 1 ´1
L(T, S) = −1
P (T, S) τ
1
Notice that the amount P (T,S) at time S is equivalent to 1 at time T, in-fact

1
P (T, S) =1
P (T, S)
1
Therefore P (T,S) at time S, which is equal to 1 at time T, is equal to P(t,T) at time t. So, we can
write ³ ³ 1 ´1´
F R A(t , T, S, N , K ) = N τ K − −1 P (t , S)
P (T, S) τ

F R A(t , T, S, N , K ) = N (K τP (t , S) − P (t , T ) + P (t , S))

From this, with nominal = 1, the fixed rate of the FRA is given by
³ P (t , T ) − P (t , S) ´ 1
K=
P (t , S) τ

1
 2 I NTEREST R ATE S WAP
The discounted payoff of a payer IRS can be expressed as (with nominal equal to 1)

β
P S(α, β, K , 1) = P (t , Ti ) τi (L(Ti −1 , Ti ) − K )
X
i =α+1

β
P S(α, β, K , 1) = P (t , Tα ) − P (t , Tβ ) − K
X
P (t , Ti )τi
i =α+1