Online Finance Course – Pricing Interest Rate Swaps – What is a Swap?
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 priced to have a value of zero at inception.
Interest Rate Swap
In a standard (plain vanilla) IRS, the buyer of the contract, usually a company, pays a predetermined fixed rate (F) payment leg and receives a floating rate(R) payment leg which is usually linked to some index (such as LIBOR).
Both payments are based on the same notional amount (Q) and period of time. The principal amount is not exchanged in an IRS. Usually there is a difference check at each payment point and the party that is obligated to pay more will make the payment of the difference between the two cash flows.
The payment on the fixed rate leg is easy to calculate, assuming same basis, the notional value is Q, and the F is the fixed swap rate:
The floating side, with R as the floating rate is
The net cash flow for the buyer of the contract at each payment date is:
Net Cash flowt=Q×(Rt-1-F)× days,
where t-1 is the payment date on which the floating rate interest was observed and is one payment date prior to the payment date on which the net cash flow is paid. “days” are the period of time in the interest rate period (in years) based on the appropriate day count convention.
The fixed rate in the IRS that makes the value of the IRS zero at inception is known as the swap rate.
A currency swap exchanges the principal and interest payments in one currency with the principal and interest payment in another currency. The principals will be exchanged at commencement and expiration of the contract. At the initial stage the principals are usually equivalent based on the prevailing exchange rates at that point in time. However at the expiration date even though the principal amounts will not change, their actual values could be significantly different based on how the two currencies have moved in relation to each other.
Online Finance Course – Pricing Interest Rate Swaps – What is swap – End Session Three