IF we take two option on the same strike
1st – long on interest rate call and
2nd – short on interest rate put
then how is this equivalent to receiving floating and paying to fix FRA?
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In a receive floating fra u stand to gain when floating is higher than fixed rate ( lets say 6% > 5% fix) and will lose if the rate stays below the fixed rate.
Similarly for a long call and short put with the same strike i rate, u gain when i rates are above the strike on account of the long call and lose on account of the short put when i rate at maturity is below the strike
suppose, I entered into long call interest rate with a strike rate of 5%
and short put on the same interest rate strike rate of 5%
for the three month maturity
so after 3 months if the interest rate is supposed 8% then my call is exercised and I get the floating rate (say 8%-5% = 3%), and my put option is out of money so it lapsed then what is fixed leg here?
If after 3 months if the interest rate is supposed 3% then my call lapses and short put option is exercised so I have to pay the 5% – 3% = 2% so this is also floating leg in this case ,
here I am not able to understand the fixed leg payment
Think from the payoff point of view as in the overall floating minus fixed rate.
If the rate happens to be 8% u are earning 8-5 = 3% in irs
Similarly, u will gain on the long call with 5% strike = 3%
In your second case
If the rate is 3 payoff from swap = -2% (3-5)
And short call exercised against us with a payoff = -2%