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What is the difference in utility for cap/floor and FRA? To me their function looks very similar. Are they used for different objectives. One thing I know in difference is that the pay off for cap is paid at the end of the term and for FRA the pay-off is calculated at the end but paid at beginning of the term with discounting incorporated. Please advise if I am wrong anywhere

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  • $\begingroup$ A FRA is used to fix a future interest rate at a particular level. A cap is used to make sure a future interest rate does not exceed a particular level. For example, you could use a FRA to fix your borrowing rate in a years time to be 2.5%. If the realised rate in a year is 3% the FRA will pay you 0.5%. If the realised rate 2%, you will need to pay 0.5%. The cap can be used to cap your rate at 2.5%. If the realised rate is 3% the cap will also pay you 0.5% but if the realised rate is 2% you will not need to pay anything (so you can borrow at 2%). Clearly the cap costs more because of this! $\endgroup$ – Chris Taylor Aug 28 '19 at 7:15
  • $\begingroup$ Okay so the FRA is like a combination of a cap and a floor at the same rate? $\endgroup$ – Rejath Johny Aug 28 '19 at 7:20
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    $\begingroup$ A FRA is equivalent to buying a cap and selling a floor at the same rate (this is called put-call parity). $\endgroup$ – Chris Taylor Aug 28 '19 at 7:29
  • $\begingroup$ Another thing you can say is Caps and Floors provide one sided hedging of interest rates, FRA provides complete (two sided) hedging. $\endgroup$ – noob2 Aug 29 '19 at 0:11

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