Discount formulas

CFA Level II Derivatives
#1

I feel like I am overlooking something very simple here- I have memorized the formulas well enough to get these questions right, but I can’t seem to recall why the different products use different calculations for discounting?

For example, when discounting the difference in interest to value a FRA at maturity, you discount by (1+(r *(days/360)).

When discounting the PV of coupons to be received in order to price a forward contract on a bond, you use (1+r^(days/365)).

Ignoring the 360vs365, why are these different? For example, just using 90/360 and 5% interest:

1 + (.05*(90/360) = 1.0125

1.05^(90/360)= 1.01227

I get the feeling this is like that psychological effect where looking at word over and over will make you start to doubt its spelled correctly… Ive done so many of these problems that I am starting to drive myself insane. Any help?

#2

For short term instruments (<1yr) like t-bills, fras etc use simple interest. For medium & long term ones use compound interest.

#3

Remember that LIBOR and Euribor are nominal rates, not effective rates.

FRAs and swaps usually use LIBOR or Euribor rates.