A forward rate agreement (FRA) is an agreement between two parties to exchange a fixed interest payment for a floating interest payment. FRAs are OTC derivatives - forward contracts in which one party (which is referred to as the borrow or buyer) pays a fixed interest rate, and another party receives a floating interest rate equal to a reference rate (the underlying rate). The receiver is also referred to as the lender or seller. The payments are calculated over a notional amount over a certain period and netted - in other words, only the differential is paid on the termination date.

Interest rate options give buyers the right, but not the obligation, to synthetically pay (in the case of a cap) or receive (in the case of a floor) a predetermined interest rate (the strike price) over an agreed period.

Similarities

  • Both Interest rate options and FRAs have interest rates as their underlyer.
  • Both use put or call formats.
  • Both use a notional amount to define the size of the trade.
  • Neither requires an exchange of principal.

Differences

  • An FRA is a commitment to make one interest rate payment and receive another one at a future date while an option is the right to make one interest rate payment and receive another one.
  • Interest rate options have exercise rate or strike rate instead of an exercise price like an FRA.

Option Payoffs
Payoffs for interest rate options function are similar to other options. The main difference is that the interest rate options take the days to maturity attached to the agreement into account. Also, the payoff from the option is not made until the end of the number of days attached to the rate. For example, if an interest rate option expires in 60 days and is based on 180-day LIBOR, the holder will not be paid for 180 days.

Interest rate call option payoffs are determined by the following formula:
 

Formula 15.3

Interest rate put option payoffs are determined by the following formula:
 

Formula 15.4

Note that in each of the formulas above, the result of the equation is multiplied by the notional amount.

Interest Rate Caps and Floors

Related Articles
  1. Managing Wealth

    Managing Interest Rate Risk

    You need certain tools to manage the risk that comes with changing rates.
  2. Trading

    Exploring The World Of Exotic Options

    Exotic options provide investors with new alternatives to manage their portfolio risks and speculate on various market opportunities. The pricing for such instruments is considerably complex, ...
  3. Trading

    How & Why Interest Rates Affect Options

    The Fed is expected to change interest rates soon. We explain how a change in interest rates impacts option valuations.
  4. Trading

    Options Pricing

    Options are valued in a variety of different ways. Learn about how options are priced with this tutorial.
  5. Trading

    Three Ways to Profit Using Put Options

    A brief overview of how to profit from using put options in your portfolio.
  6. Trading

    Trading Options on Futures Contracts

    Futures contracts are available for all sorts of financial products, from equity indexes to precious metals. Trading options based on futures means buying call or put options based on the direction ...
Frequently Asked Questions
  1. When are Beneficiaries of a Will Notified?

    Learn when the beneficiaries of a will must be notified, and understand how this requirement varies depending on whether ...
  2. Why Does Larry Page Pay Himself a $1 Salary?

    Google co-founder Larry Page continues to take an annual salary of only $1 as chief executive officer.
  3. What is Common Stock and Preferred Stock?

    Learn about the differences between common and preferred shares. Explore situations where preferred shares have more favorable ...
  4. Can CareCredit be Used for Family Members?

    Learn more about the available options that CareCredit offers to pay for out-of-pocket medical procedures with little to ...
Trading Center