Mirza Imtiaz Askari [FRM]

A swap is an agreement between two parties to exchange cash flows in the future. The agreement specifies;
Dates when cash flows will be exchanged. How Cash flows will be computed.

Futures/Forwards and FRAs specify cash flows on just one future date. Swaps specify cash flows on several future dates.

Interest Rate Swaps

Plain Vanilla Step Up Swaps Amortizing Swaps Compounding Swaps

Currency Swaps
Fixed for Fixed Floating for Floating Cross Currency

LIBOR in Arrears Swap Constant Maturity Swap Constant Maturity Treasury Swap Differential Swap Equity Swaps Swaps with Embedded Options Accrual Swaps Cancelable Swaps Cancelable Compounding Swaps

In this swap one party agrees to pay cash flows equal to Fixed interest rate x Notional Principal in return for cash flows equal to Floating rate x Notional Principal. Notional Principal Many Future Dates Fixed Interest Rate Floating Interest Rate [LIBOR]

Party A Pay Fixed Rate 10% Party B Pay Floating Rate Notional Principal Rs 100 m March 25 and September 25 of each year for 2 years
(Rs 5m) Rs 4.75m (Rs 5m) Rs ? (Rs 5m) Rs ? (Rs 5m) Rs ?

Party A Pays Party A Receives

Today

March 25, 2012

September 25, 2012

March 25, 2013

September 25, 2013

The Maturity, or Tenor, is normally

between 1and 15 years.

By Convention;
Fixed-rate payer is the buyer. Floating-rate payer is the seller.

Interest rate swap terms typically are set so that

PV of Cash flows Paid = PV of Cash flows Received

= = ( /)

EXAMPLE Notional = $100 million Initiation = January 2011 Maturity = December 2013 Issuer paying the Swap Rate (fixed rate) Issuer Receiving 6-month LIBOR (floating rate) Payments are assumed to be made on a semi-annual basis (i.e., 180-day periods).

Years Spot Rate Forward Rate 0.5 9% 9% 1.0 9.125% 9.25% 1.5 9.25% 9.5% 2.0 9.375% 9.75% 2.5 9.5% 10% 3.0 9.625% 10.25%

 = = ( /)

,, = =.% ,,

Swap is simply a series of cash flows, therefore, its value is determined by computing the present value of each cash flow.

QUESTION ?
ANSWER;

What is the appropriate discount rate?

Generate a LIBOR SPOT CURVE using

Forward rates implied by FRAs or Convexity Adjusted Eurodollar Futures

1.

Valuing an Interest Rate Swap with Bonds

2.

Valuing an Interest Rate Swap with FRAs

Party A Pay Fixed Rate 10% Party B Pay Floating Rate

Party A Party B

Party A: Cash Outflow Fixed Cash Inflow Floating

Short Position Long Position

Notional = Rs 100 m Pay Fixed = 10%

Party A Pays Party A Receives

(Rs 5m) Rs 4.75m

(Rs 5m) Rs ?

(Rs 5m) Rs ?

(Rs 5m) Rs ?

Today

March 25, 2012

September 25, 2012

March 25, 2013

September 25, 2013