The same methodology will be used to price floating for floating or basis swaps, except that zero curves and forward rates will be derived for both legs of the swap accordingly.
The following basis swap has been priced below:
Term SheetArchives for May, 2010
Online Finance – Pricing Interest Rate Swaps – Pricing Basis Swap
30th May 2010 by Jawwad under Derivatives
Pricing Basis Swaps or Floating for Floating Swaps
Online Finance – Pricing an Interest Rate Swap – Calculating the MTM of the Swap
30th May 2010 by Jawwad under Derivatives
Step 13: Determine the cash flows
The cash flows for the receiving and paying legs are as follows:
Online Finance Course – Pricing Interest Rate Swaps – Calculating the forward curve
30th May 2010 by Jawwad under Derivatives
Deriving the Forward Curve
Step 9: Deriving forward rates
In order to derive forward rates from the zero coupon rates for successive interest rate periods the bootstrapping methodology has been employed. In particular the following formula has been used:
Where t is the tenor in years, ZCt is the zero coupon rate for a tenor of t years and FCt-1,t is the forward rate for the period (t-1,t).
For…
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30th May 2010 by Jawwad under Derivatives
Deriving the Forward Curve
Step 9: Deriving forward rates
In order to derive forward rates from the zero coupon rates for successive interest rate periods the bootstrapping methodology has been employed. In particular the following formula has been used:
Where t is the tenor in years, ZCt is the zero coupon rate for a tenor of t years and FCt-1,t is the forward rate for the period (t-1,t).
For…
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30th May 2010 by Jawwad under Derivatives
Deriving the Zero Curve
We use the bootstrapping method for deriving the zero curve from the par term structure. This is an iterative process that allows use to derive a zero coupon yield curve from the rates/ prices of coupon bearing instruments. The step by step procedure employed in given below:
Step 4: Develop the cash flows matrixGiven the default par term structure above we calculate the cash flows for coupon…
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30th May 2010 by Jawwad under Derivatives
Defining the Par Term Structure
Step 1: Select an appropriate term structure
Based on the interest rate swap being priced an appropriate term structure or structures will be chosen. This is an important process because both the zero curve and the forward curves are derived from it which are in turn used to discount the cash flows and calculate the future coupon rates for the floating legs of the transaction.
Let us…
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30th May 2010 by Jawwad under Derivatives
Pricing Interest Rate Swaps
The following process will be followed when determining the value or price of an interest rate swap. Firstly, a default par term structure will be defined. This consists of selecting an appropriate par term structure based on the terms of the interest rate swap, in particular the coupon rate payments and the frequency of the payments. As given par structures may only be available for specified…
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30th May 2010 by Jawwad under Derivatives
Swaps
This is an agreement between two parties, usually institutions, to exchange cash flows according to a predefined calculation at specified periodic intervals in the future. The calculation may be based on the future value of interest rates, foreign exchange rates or some other market variable. Like forward and futures contracts both parties to the contract are obligated to perform their end of the deal. Also like forward and futures contracts swaps are…
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30th May 2010 by Jawwad under Derivatives
Online Finance Course – Pricing Interest Rate Swaps – More terminology
Relationship between Spot and Forward Rates
The following formulas summarize the relationship between the spot and forward rates of interest:
ft-1,t = (1+st)t ÷ (1+st-1)t-1 – 1
or alternatively
As can be seen above the spot rates are geometric averages of the forward rates of interest.
Forward rates do not generally do a good job of actually predicting the future rate, but…
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30th May 2010 by Jawwad under Derivatives
Online Finance – Pricing Interest Rate Swaps – Session One
Definitions
Cash flows
The key to pricing or valuing any instrument is to estimate the cash flows of the instrument and discount each cash flow using an appropriate rate of interest.
Cash flow is simply the cash that is expected to be received each period from an investment. For a bond this includes coupon and principal payments; for an interest rate swap this…
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