● A swap is an agreement between two parties to exchange a series of cash flows, which
can also be viewed as a series of forward contracts.
● Swap pricing is the determination of the initial terms of the swap at the inception of the
contract.
● On the other hand, swap valuation is the determination of market value during the
life of the swap contract.
● Swaps are equivalent to a series of forward contracts, each created at the swap
price.
● If the present value of the payments in a swap or forward contract is not zero, then the
party who will receive the greater stream of payments must pay the other party the
present value of the difference, i.e., the “net" value. ("Remember the $30 vs $28 swap
example, PV of $2 is paid to the one who receives less money).
● Usually, the floating rate is based on the LIBOR, e.g., LIBOR + 1.1% OR LIBOR + 1%
●
At inception, the value of an interest rate swap is zero.
● Therefore, the fixed rate on the swap has to be such that the present value of the
fixed payments is equal to the present value of the floating payments. (Pushing the
difference between fixed and floating payments to zero).
● Fixed rate swap can be treated like buying a fixed rate bond, and issuing a floating
rate bond. (You have to pay a floating rate, and to hedge against interest rate
fluctuations, you receive fixed payments. Below is outlines your position (in terms of
bond purchases, as a fixed rate receiver).
○ Value of swap (receiving fixed) = Value of fixed-rate bond (long) – Value of
floating-rate bond (short) (basically you are borrowing to purchase asset)
● The value of a swap is its market value at any point in time. At inception, the value of an
interest rate swap is zero. The price of the swap refers to the initial terms of the
swap at the start of the swap’s life.
FX Swap:
● AU/USD → AU is price of currency (f), USD is base currency (d)
● No. of AU per USD
● AU is f, USD is d
● F0,f/d = S0,f/d x (1+rf)^T/(1+rd)^T
● Remember to PV the profits/ values of swaps
Qn: U.S. and Mexico risk-free rates are 6% and 8% respectively. Current spot exchange rate is
$0.0845 per Mexican peso. What is the no-arbitrage 180-day forward currency price of peso (in
$ per peso) ? Use discrete annual compounding.
Qn: A trader enters into a forward currency position by buying 10 million £ at 3-month $/£
forward rate of 1.6540. After 1 month, the spot exchange rate becomes $/£ 1.6650. The U.S.
and U.K. interest rates at the end of 1 month are respectively 2% and 3%. You can use discrete
annual compounding for calculating interest costs. What is the value of the forward contract to
the trader at the end of 1 month in terms of pounds?
Forward Rate Agreements (FRA) & Interest Rate Swaps (IRS)
● IFRs can be derived from risk-free bonds/ notes’ spot rate curves
● IFR is approximately MRR, if MRR has zero the same credit-risk as the risk-free bond
● FRA has single settlement, settled at the beginning of the interest period
● Swaps have periodic settlements, at each of respective periods
○ Terminologies:
○ OTC FRAs cash-settled at settlement date (beginning of interest period)
○ FRA with 3 months waiting period (to settlement, payment of FRA) and 6
month contract period (when they receive swap payments) is 3 x 9 FRA
● Buyer of FRA pays fixed contract interest rate, receive floating payments (based on
market reference rate (MRR))
○ MRR is settlement rate, FRA/ IFR is contract fixed rate
○ FRA or contract fixed rate is IFR of spot rate curve of bonds/ notes with
similar zero credit risk as MRR
● Interest differential, received at end of 9 months:
○ [Settlement rate (MRR) - Contract rate (FRA/IFR)] x (Days in contract period/
360) x notional amount
Swaps as a combination of FRAs
● FRA settlement amount:
○ Interest differential/ [1 + settlement rate(days in contract period/ 360)] → PV of
interest differential at settlement. Computed at settlement date, t = 3 months.
○ (1 + Za)^a(1 + IFRa, b-a)^b-a = (1 + Zb)^b → IFR formula. Note that Z is zero
credit risk bond rate
■ IFRa,b-a = [(1+Zb)^b/(1+Za)^a] - 1
■ Note that Zs are Zero Rates of coupons/ bonds
● Treat the swap as a combination of FRAs, so you’d need to get the IFRs for the different
periods.
●
● Then, you’d need to get the PVs of the IFRs, using annual compounding
●
● Therefore, the above PV of IFRs is the fixed rate for the swap/ interest rate swap = par
swap rate
○ Compounded using risk-free rates, as per usual, in this case the zero rates
○ In the below example, swap rate is S3:
○
● Par swap rate = the fixed rate that equates the PV of all future expected floating cash
flows to the PV of fixed cash flows
● (fixed-rate receiver/ fixed-rate payer) IRS, like buying/ selling fixed rate bond and selling/
buying floating rate note
○ Only interest payments are swapped. There is no exchange of the notional
principal
● Value of interest rate swap to fixed-rate payer, need to find C:
●
Qn. A 1-year plain vanilla interest rate swap has quarterly settlements. Notional principal is $10
million. The annualized MRR spot rates today are: R90-day = 0.030, R180-day = 0.035,
R270-day = 0.040, and R360-day = 0.045. Find the fixed rate (or swap price) in percentage
terms. Find the quarterly fixed payments in $.