Module 40.6 LOS 40.j: Equivalencies in Interest Rate Derivative Contracts & Swaps

We can use interest rate options to create positions that mimic other contracts.

For example, by combining a long interest rate call and a short rate put, we can replicate a long FRA. If the exercise rate of the option is the same as the current FRA rate, a short rate call and a long rate put can mimic a short FRA.

We can create an interest rate cap by buying interest rate call options with different maturities but the same exercise price. A similar interest rate floor can be made using interest rate put options. When the exercise rate on a cap and floor are the same, we can make a payer swap. By shorting a cap and longing a floor we create a receiver swap.

In the case of swaps, we can make a long receiver swaption by going long on a receiver swaption and short on a payer swaption that have the same exercise rates, and we can make a payer swap by reversing those positions.

We can also create a long callable bond going long on an option-free bond and shot on a receiver swaption.

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