Interest Rate Options vs. FRAs

Forward rate agreement (FRA)
· an agreement between two parties to exchange a fixed interest payment for a floating interest payment.
· FRAs are OTC derivatives - forward contracts in which one party (which is referred to as the borrow or buyer) pays a fixed interest rate, and another party receives a floating interest rate equal to a reference rate (the underlying rate). The receiver is also referred to as the lender or seller.
· The payments are calculated over a notional amount over a certain period and netted - in other words, only the differential is paid on the termination date.

Interest rate options
· Give buyers the right, but not the obligation, to synthetically pay (in the case of a cap) or receive (in the case of a floor) a predetermined interest rate (the strike price) over an agreed period.

Similarities
· Both Interest rate options and FRAs have interest rates as their underlyer.
· Both use put or call formats.
· Both use a notional amount to define the size of the trade.
· Neither requires an exchange of principal.

Differences
· An FRA is a commitment to make one interest rate payment and receive another one at a future date while an option is the right to make one interest rate payment and receive another one.
· Interest rate options have exercise rate or strike rate instead of an exercise price like an FRA.