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forward basics
Hull suggests (in 6th ed) that, when valuing an FRA (VFRA = L(Rk-Rf)(T2-T1)e^-R2T2), that Rk and Rf are to be compounded at the discreet frequency (T2-T1). I'm having a bit of difficulty in getting my head around the net flows. Is it essential that Rk and Rf be compounded discreetly? What exactly is it about the nature of the FRA that requires this, if so?Thanks in advance for some perspective.
Last edited by chazw on October 25th, 2007, 10:00 pm, edited 1 time in total.
forward basics
As far as I know, FRA contracts are usually specified in terms of _simply compounded_ rates, most of the times with the same convention used for the floating legof IRS contracts. This makes sense because you can see a vanilla IRS as a portfolio of FRA's. Going deeper into the matter, one might ask where the conventionsfor interest rate swaps came from. My guess is that they were related to the conventions for bonds, which have never been based on continuous compounding.Hope it helps