You are paying 5% per annum paid semi-annually and receiving 6-month LIBOR on a USD 10 million interest rate swap with exactly two years to maturity. 6-month LIBOR for the next payment date is fixed today at 4.95%. How would you hedge the swap using FRAs? How to hedge an IRS with a strip of FRAs?
A) buy a strip of 0x6, 6x12, 12x18 and 18x24 FRAs
B) sell a strip of 0x6, 6x12, 12x18 and 18x24 FRAs
C) buy a strip of 6x12, 12x18 and 18x24 FRAs
D) sell a strip of 6x12, 12x18 and 18x24 FRAs

Question

Quizplus · Accepted Answer

To hedge the swap using FRAs, we need to sell FRAs to receive fixed rate payments equivalent to the floating rate payments we are making on the swap. We will need to sell FRAs that expire on each of the six-month periods when we need to pay the floating rate on the swap. 
We have 4 payment dates (semi-annual), starting from today, and LIBOR is fixed for the first one. Therefore, we need to sell FRAs for the remaining 3 periods (6x12, 12x18, and 18x24) to cover our cash flow. Selling the FRAs will generate cash at the inception of the position, which can offset our fixed rate payments on the swap. Therefore, the best choice is to sell a strip of 6x12, 12x18 and 18x24 FRAs.

You Are Paying 5% Per Annum Paid Semi-Annually and Receiving