Anyone follow how Peter is achieving Step 2 in his calculations of the value of an FRA prior to expiration? Seems much more confusing than the notes and i can’t track the maths at all…
Right around the 2:07hr mark.
TIA
is this when both sides of the Equation is divided by 1 and then first term of the right hand side is moved to left hand side and then eventually right hand side is subtracted from left hand side…something like this…and then you get the value of the FRA.
If yes, then me neither, it’s just in my opinion a simpler way of remembering the formula of calculating value of FRA (Vs. the formula in the book)
Yeah, that’s the part, but the math he shows doesn’t really make sense…
As I don’t have the video I cannot comment (except to say that I really like Peter; he and I worked together at Stalla).
Maybe this article I wrote will help a bit: http://financialexamhelp123.com/valuing-fras/.
Thanks S2000magician, I certainly understand that example and that is consistent with the notes/text. What Peter does is effectively combine the last two steps. I can’t quite figure out how he goes about it, though.
The question is to value a 30x150 FRA that’s 20 days in. The original value is 6.2241, 10 day libor is 5.5 and 130 is 7, principal is 1mm.
He sets:
0.07 x 130/360 = (0.055 x 10/360)(0.062241 x 120/360)
0.025278 = (0.001528)(0.020747)
Then he says we’re going to “solve for value” and “add 1 to the rates and divide both sides of the equation by 0.025278” and gets to:
Value = 1/1.001528 - 1.020747/1.025278
Which works out to the right answer. I can see what he’s doing here in terms of substituting in the original FRA value and solving for the value difference that essentially makes the 130 day rate balance to the 10 day rate compounded with the original 120 day rate, but the equations and process above seems like a mess and I am wondering if I’m missing something a an easier way to approach these problems.
TIA.
Threw me off at first too, you’re talking about where he winds up taking the PV factor of the short term rate til expiration and subtracting the ratio of the contract rate to the long term (time til expiration + m day rate)? I think about it like this, if we were to simply calculate the value at a point in time as the second term, FRA divided by the longer term, m + time til exp rate, we would kind of be over estimating the gain since the longer term rate has the current short term rate as well as the new implied m day rate in it. However the value to us should only be based off of the FRA rate vs the change in the implied m day rate at that point in time. The first term, PV of the short term rate til exp essentially removes the effect of investing in the short term and rolling over to the new impied m day rate. You could also, just calculate the new implied m day rate at a point in time just like we did initially to come up with the FRA rate and calculate the value this way. I agree it did seem like he rushed through that one towards the end