Interest Rate Swaps

An interest rate swap is an over-the-counter derivative contract in which

counterparties exchange cash flows based on two different fixed or
floating interest rates. The swap contract in which one party pays cash
flows at the fixed rate and receives cash flows at the floating rate is the
most widely used interest rate swap and is called the plain-vanilla swap or
just vanilla swap.
You can think of an interest rate swap as a series of forward contracts.
Because an interest rate swap is a tailor-made contract purchased over
the counter, it is subject to credit risk. Just like a forward contract, the
swap has zero value at inception and hence no cash changes hand at
initiation. However, a swap must have a notional amount which represent
the amount to which interest rates are applied to calculate periodic cash
flows.
Let’s say you have a 5-years $100 million loan at a variable interest rate
which equals LIBOR plus a spread of 100 basis points. You would prefer
to pay a fixed interest rate to be able to better forecast your cash flow
requirements. You can’t go back to the bank and change the loan to a
fixed-rate loan. However, you can manage your risk by entering a fixed-
for-floating interest rate swap which requires you to pay an amount
determined based on a fixed rate and receive an amount calculated at the
floating rate. You can match the amount and timing of the swap cash flows
you receive with the cash flows you are required to make on the loan.

Pricing of interest rate swap

You can think of a pay fixed, receive floating swap as a combination of a
long position in a fixed rate bond and a short position in a floating rate
bond. This is because you will receive cash flows equal to the periodic
cash flows on a fixed-coupon bond and you must pay cash flows which
can be replicated as equivalent to coupons on floating rate bond.
The value the swap thus equals the difference between the present value
of fixed cash flows and present value of variable cash flows:

Swap Rate
The swap rate is the rate that applies to the fixed payment leg of a swap. It
can be worked out using the following equation:
It means that the fixed rate on the swap (let's call it c) equals 1 minus the
present value factor that applies to the last cash flow date of the swap
divided by the sum of all the present value factors corresponding to all the
swap dates.
For a fixed-for-floating interest rate swap, the rate is determined and
locked at initiation. However, at any point in the swap tenor, it changes
with change in floating rates. The new fixed rate corresponding to the new
floating rates can be termed as the equilibrium swap rate or equilibrium
fixed rate. The value of a swap to the party that pays fixed and receives
floating is the difference between the (new) equilibrium fixed rate (let’s say
f) minus the fixed rate negotiated and locked at initiation (referred to as c
above) at the valuation date multiplied by the sum of all present value
factors multiplied by the notional amount N. This can be expressed
mathematically as follows:

Example
Let’s say you negotiate a 2% pay fixed, receive floating swap to convert
your 5-years $100 million loan to a fixed loan. Calculate the value of your
swap one year down the road, given the following floating rates present
value factor schedule:

Year PVF

1 0.99

2 0.97

3 0.95
 4 0.94

The equilibrium fixed swap rate one year down the road is 1.56%:

Because you have locked a 2% fixed rate on the loan, the value of the
swap is -$1.7 million:

Because the current equilibrium fixed rate is lower than the rate that you
negotiated for the whole life of your swap, the current value of swap is
negative for you. This is because you have committed to pay 2% for the
life of the swap but the current floating rates structure corresponds to
1.56% fixed rate.
The value to the counterparty, i.e. the party paying floating and receiving
fixed is the exact opposite of the value above.
by Obaidullah Jan, ACA, CFA and last modified on Apr 16, 2018