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Interest rate swap terms typically are set so that the present value of the counterparty payments is at least equal to the present value of the payments to be received. Present value is a way of comparing the value of cash flows now with the value of cash flows in the future. A dollar today is worth more than a dollar in the future because cash flows available today can be invested and grown. The basic premise to an interest rate swap is that the counterparty choosing to pay the fixed rate and the counterparty choosing to pay the floating rate each assume they will gain some advantage in doing so, depending on the swap rate. Their assumptions will be based on their needs and their estimates of the level and changes in interest rates during the period of the swap contract. Because an interest rate swap is just a series of cash flows occurring at known future dates, it can be valued by simply summing the present value of each of these cash flows. In order to calculate the present value of each cash flow, it is necessary to first estimate the correct discount factor (df) for each period (t) on which a cash flow occurs. Discount factors are derived from investors¶ perceptions of interest rates in the future and are calculated using forward rates such as LIBOR. The interest rate swap market is large and efficient. While understanding the theoretical underpinnings from which swap rates are derived is important to the issuer, computer programs designed by the major financial institutions and market participants have eliminated the issuer¶s need to perform complex calculations to determine pricing. The interest rate swap market has evolved from one in which swap brokers acted as intermediaries facilitating the needs of those wanting to enter into interest rate swaps. The broker charged a commission for the transaction but did not participate in the ongoing risks or administration of the swap transaction. The swap parties were responsible for assuring that the transaction was successful. In the current swap market, a dealer-based market comprised of large commercial and international financial institutions has replaced the role of the broker. Unlike brokers, dealers in the over-the-counter market do not charge a commission. Instead, they quote ³bid´ and ³ask´ prices at which they stand ready to act as counterparties to their customers in the swap. Because dealers act as middlemen, counterparties need only be concerned with the financial condition of the dealer, and not with the creditworthiness of the other ultimate end user of the swap. A plain vanilla fixed-for-floating swap is an agreement in which one side agrees to pay a fixed rate of interest in exchange for receiving a variable/floating rate of interest during the tenor (maturity) of the swap. The other counterparty to the swap agrees to pay floating and receive fixed. The two interest rates are applied to the swap¶s notional principal amount. The fixed rate, also called the swap rate, is set against a floating reference rate (which is usually LIBOR, the London Inter-Bank Offered Rate). The floating rate is reset several times over the swap¶s life ± usually every three to six months. Since the interest payments are computed on the same notional principal for both the counterparties, there is no exchange of principal between them at maturity.
since the cash flows are known. one method of valuation of a swap on any date after it is initiated is to equate the present value of the floating payments on a reset date to par and net out its present value from the present value of the fixed payments on the valuation date. in principle. the market value of the swap is usually set to zero. be imputed from the prices of Eurocurrency futures contracts. they can.Interest rate swaps of all types and maturities are traded in the over-the-counter (OTC) markets. which can be easily valued. An alternative method of valuing a swap contract is to treat it as the sum of a series of forward rate agreements (FRAs).. This would yield an annuity equal to the difference between the fixed payments at the original swap rate and the new swap rate. In the absence of default risk. This follows because the cash flows of a default-free par swap can be replicated by the cash flows of a portfolio of FRAs maturing at consecutive settlement dates. At the initiation date. At each swap payment date. . the arbitrage-free fixed swap rate should equal the yield on a par coupon bond that makes fixed payments on the same dates as the floating leg of the swap. the gain or loss in the currently maturing implicit forward contract is realized. A third method for valuing a swap is by considering a reversal of the swap at the market swap rate. Since FRA rates are not always readily quoted. Hence.