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…

Under a 2-year interest rate swap paying 5% fixed and receiving 6-month LIBOR semi-annually, you face downside risk if future floating rates fall. To hedge against falling rates, you must receive fixed and pay floating in the derivative market, which corresponds to selling Forward Rate Agreements (FRAs). The swap consists of four semi-annual calculation periods (0-6m, 6-12m, 12-18m, 18-24m). Because the initial 6-month LIBOR rate (0-6m) is already fixed today at 4.95%, it carries zero interest rate exposure and does not require hedging. The remaining three unfixed future periods are hedged by selling a strip of 6x12, 12x18, and 18x24 FRAs.

A. This option incorrectly includes a 0x6 FRA, which is redundant because the first period's fixing is already known today.

B. Buying FRAs means paying fixed and receiving floating, which doubles the existing swap risk rather than hedging it, and contains invalid period labels.

C. Buying FRAs is the opposite trade required to hedge a receive-floating swap exposure and unnecessarily includes the already-fixed 0x6 period.

1. ACI Financial Markets Association, ACI Dealing Certificate Topic 4: Money Market Derivatives - FRAs and Interest Rate Swaps.

2. Fabozzi, F. J., Fixed Income Mathematics, McGraw-Hill, Chapter on Hedging Swap Portfolios with FRAs.

3. OpenCourseWare / Finance Coursework, Interest Rate Derivatives and Hedging Strategies: Stripping FRAs for Swap Risk.