318 Frequently Asked Questions In Quantitative Finance
typically have a spread in excess of a government interest
rate, and this spread allows for credit risk. The coupons
may also have a cap and/or a floor. The most common
measure of a floating interest rate is the London Interbank
Offer Rate or LIBOR. LIBOR comes in various maturities,
one month, three month, six month, etc., and is the rate
of interest offered between Eurocurrency banks for fixed-term
deposits.
Floor is a fixed-income option in which the holder receives
a payment when the underlying interest rate falls below a
specified level, the strike. This payment is the strike less the
interest rate. These payments happen regularly, monthly, or
quarterly etc., as specified in the contract, and the underlying
interest rate will usually be of the same tenor as this interval.
The life of the floor will be several years. They are bought for
protection against falling interest rates. Market practice is to
quote prices for floors using the Black ’76 model. A contract
with a single payment as above is called a floorlet.
Forward is an agreement to buy or sell an underlying, typi-
cally a commodity, at some specified time in the future. The
holder is obliged to trade at the future date. This is in con-
trast to an option where the holder has the right but not the
obligation. Forwards are OTC contracts. They are linear in the
underlying and so convexity is zero, meaning that the volatil-
ity of the commodity does not matter and a dynamic model is
not required. The forward price comes from a simple, static,
no-arbitrage argument.
Forward Rate Agreement (FRA) is an agreement between two
parties that a specified interest rate will apply to a specified
principal over some specified period in the future. The value
of this exchange at the time the contract is entered into is
generally not zero and so there will be a transfer of cash from
one party to the other at the start date.
Forward-start option is an option that starts some time in the
future. The strike of the option is then usually set to be the
value of the underlying on the start date, so that it starts
life as an at-the-money option. It is also possible to have
contracts that begin in or out of the money by a specified
