Explanation:
Using a sequence of forward rate agreements (FRAs) to replicate a swap provides flexibility because each FRA can be individually customized in terms of notional amount and settlement dates. This is advantageous in managing liabilities or adjusting to changes in market conditions. While swaps are standardized and often require long-term commitments, FRAs offer modularity, allowing adjustments over time. Choice A is incorrect because FRAs do not inherently reduce counterparty risk compared to swaps. Choice B is incorrect because FRAs, like swaps, require monitoring of interest rate movements to assess potential obligations. Choice C is incorrect because while FRAs can replicate swap cash flows, they do not eliminate collateral requirements.
(Book 3, Module 46.2, LO 46.h)
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Question 38
Which of the following statements best explains why a financial intermediary might prefer to use a sequence of forward rate agreements (FRAs) to replicate the cash flows of an interest rate swap?
A
FRAs allow the intermediary to reduce counterparty risk by using a decentralized trading structure.
B
The replication strategy using FRAs eliminates the need to monitor market interest rate movements.
C
The cash flows of a swap can be perfectly replicated using FRAs without requiring upfront collateral.
D
FRAs provide more flexibility in adjusting notional principal and payment schedules compared to swaps.
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