rkapoor

Generally, you can replicate short forward contracts by buying a put and selling a call. I find it handy to think about these in terms of payoffs. If you are short the FRA, you have a linear payoff with respect to rates on the valuation date. That is, if you graph payoff vs. rates, you will get a straight, downward sloping line where payoff = 0 when rates = the strike. By buying the put, you replicate the positive part of this payoff diagram. By selling the call, you replicate the negative part of this payoff diagram.