# Chapter 13 Pricing and Valuing Swaps

Pricing a Swap: Calculating the ³fair fixed rate.´ The idea: Calculate a fixed rate whereby market participants are indifferent between paying (receiving) this fixed rate over time or paying (receiving) a rate that can fluctuate over time. This is accomplished by setting the value of the swap equal to zero at origination. This is achieved when the present value of the two (expected) cash flow streams equal each other.

©David Dubofsky and 13-1 Thomas W. Miller, Jr.

Valuing a Swap: Because a swap is equivalent to an asset and a liability. Jr.Pricing and Valuing Swaps. II. At origination. a swap will have zero value.
. Miller.
©David Dubofsky and 13-2 Thomas W. However. one can just value each of them to determine the value of the swap at any moment in time. ³off-market´ swaps will not have a zero value at origination.

Define r(t1.3) = 10.01%. r(0.2) = 6%.t) as the spot interest rate for a zero coupon bond maturing at time t.t2) as the forward interest rate from time t1 until time t2. Miller.3) = 7. and fr(2.564%.
. Jr.2) = 7. Assume the zero (spot) term structure is: r(0.5%. Therefore the forward rates are: fr(1.1) = 5%. These forward rates should exist in the FRA and futures markets.
Define r(0. r(0.Pricing a Plain Vanilla Interest Rate Swap. I.
©David Dubofsky and 13-3 Thomas W.

the ³expected´ floating rate cash flows are:
CF1 = (0.
. Thus. Miller.01 CF3 = (0.564 CF3 = 100
©David Dubofsky and 13-4 Thomas W. The floating rate is the one-year LIBOR.Pricing a Plain Vanilla Interest Rate Swap.e. What is the ³fair´ fixed rate? (I. Assume (for convenience) that NP is exchanged.. Settlement is yearly. Jr.05)(100) = 5 CF2 = (0.
Now consider a swap with a tenor of 3 years.1056)(100) = 10. Arbitrarily set NP = $100. II.0701)(100) = 7. what is the ³price´ of a swap under these conditions? Let the forward rates be the expected future spot rates.

01 10 . immediately after a floating payment has been made.Pricing a Plain Vanilla Interest Rate Swap. 075 )
An important lesson: The the value of the floating rate side of the swap equals its NP. III. 05 (1 .
. Miller. 06 ) (1 . Jr. 075 ) (1 .
©David Dubofsky and 13-5 Thomas W. 564 100 ! 100 2 3 3 1 .
Value these expected cash flows at the appropriate discount rates: the spot zero coupon interest rates:
5 7 .

.075) (1. A ! 7.05) (1.06) (1.
Because the value of a swap at origination is set to zero. 96 2 3¿ (1. 73a! 19.075) ¾ ® 1 1 1 A¯ ! 100 80. Miller. 7
©David Dubofsky and 13-6 Thomas W. IV.05) (1.075) À ° A_ .06) (1. Jr. the fixed rate payments must satisfy:
A A A 100 ! 100 2 3 3 (1.Pricing a Plain Vanilla Interest Rate Swap.

the swap dealer might quote 7.
. Miller.39% to a fixed-rate payer. the value of the swap will change.Pricing a Plain Vanilla Interest Rate Swap. and 7. However. if the yield on the most recently issued 3-year T-note is 7.
Thus.05%. the valuation method remains the same.
©David Dubofsky and 13-7 Thomas W. Equivalently. the quoted swap spreads would be 30 bp (bid) to 34 bp (asked). If interest rates change. Jr.35% to a fixedrate receiver. V.

If prices or rates subsequently change.Valuing a Swap after Origination.value) for the other (the party who could default).
. It will become an asset (+ value) for one party. Jr. and a liability (.
©David Dubofsky and 13-8 Thomas W. immediately after a CF has been swapped. the valuation method (compute the PV of the contracted fixed cash flows and of the expected variable cash flows) remains the same. the value of the swap will change. But. one can make use of the fact that PV(floating CF) = NP. Miller. I. Also.

the yield curve flattens at 7%.
©David Dubofsky and 13-9 Thomas W.Valuing a Swap after Origination. Jr. Suppose that 3 months after the origination date. The next floating cash flow is known to be 5. Immediately after this payment is paid.
Consider the previous plain vanilla interest rate swap example. II.
. PV(remaining floating payments) = NP = 100. Miller.

07 1.75 1.07 ! V( ext ayment) V( )
.Valuing a Swap after Origination.805.
V floating 5 100 ! ! 99. 0. III.75 0.

after 3 .mont s.367 ! 102. That is. Jr. Who pays whom?
©David Dubofsky and 13-10 Thomas W.
V fixed ! .367 107.V
floating
o. 0. Miller.685. V floating
as decreased.685 ± 99. s i cr s .75 2.07 1.88 today to eliminate this swap.75 1.07 1. (102. fixed
The swap¶s value is $2.805). per $100 of NP.07 ft r 3 t s.75 1.
. one would have to pay $2.367 7.88.
7.

with an original tenor of 4 years. r1 = 5%. the Japanese interest rate rises to 2%.
©David Dubofsky and 13-11 Thomas W. interest rates remain unchanged. and the spot exchange rate becomes ¥102/$.040MM yen. The value of the domestic payments remains at $10 million. U. and NP2 =
1. Miller. Jr.Valuing a Currency Swap after Origination
Consider the currency swap from Chapter 11.S. NP1 = $10MM. and r2 = 1%.
Suppose that 3 months after the swap origination.
.

00 0 ! $143.4MM Y10.500 $10. Miller. the value of the swap is -$143.500
For the pay-$ / receive ¥ party.75 (1.75 1.02) (1. IV.4MM Y10. Jr.75 3. 36) ! $9.02)
In terms of $ ! ($0.500.02) (1.856.4MM ! Y1005.
©David Dubofsky and 13-12 Thomas W.8565MM V ! $9.000.Valuing a Swap after Origination.02) (1.009804 /Y)(Y1005.
.36MM 0.
The value of the yen payments becomes:
VY ! Y10.4MM Y1050.75 2.

gold futures prices are:
Months to Next Delivery Date 4 10 16 22 Gold Futures Price 409. Today.20 415. beginning four months from today. Also. the term will be 22 months and the floating price will be the spot price of gold on each settlement date. I.
Here. Miller.
.Pricing a Commodity Swap.80
©David Dubofsky and 13-13 Thomas W.10 420. we will find the fixed price for a fixed-for-floating gold price swap.40 425. Jr. assuming settlement will be every six months.

33)=4. II. Based on the gold futures µterm structure¶.1. are:
r(0.
Assume the appropriate zeros.83)=4. with time expressed in years.1.0%.0.2%.33)=4.83)=4.5%.Pricing a Commodity Swap. Jr. r(0. One side of the swap is an agreement to buy gold. r(0.7%
The swap consists of an asset and a liability. the PV of these expected floating payments is:
©David Dubofsky and 13-14 Thomas W.0.
. Miller. r(0.

042) (1. Jr. III.83
! 1.10 420.593.Pricing a Commodity Swap.047) 1.33 0.40 425.072
The present value of the agreement to sell gold at the fixed price (F) is:
©David Dubofsky and 13-15 Thomas W.20 415.
.04) (1.33 (1. Miller.
409.045) (1.80 0.83 1.

83 ¿ (1.Pricing a Commodity Swap.33 (1.
©David Dubofsky and 13-16 Thomas W.072 ® 1 1 1 1 0.045)1.042)0.46 plus a profit margin.
.816093a !1. the swap dealer will quote to sell fixed at $417.593. Miller. and to buy fixed at $417.83 (1.04) À °
F_ 3.46 minus a profit margin.047)1.33 (1. Jr.
F¯
¾ ! 1.593.072
F ! $417.4615
Thus. IV.