Valuation of "Plain-Vanilla" Interest-Rate Swaps
16 Pages Posted: 21 Oct 2008
Abstract
This note takes students step by step through the valuation of an interest rate swap. It assumes students have a strong grounding in the concepts of forward rates and spot rates.
Excerpt
UVA-F-1121
VALUATION OF “PLAIN-VANILLA” INTEREST-RATE SWAPS
An interest-rate swap is a contract specifying the terms for exchanging fixed-rate interest payments for floating-rate interest payments. Such swaps have wide use in financial markets because they offer cost-effective ways to manage uncertainties about interest rates. This note introduces basic features of interest-rate swaps and focuses on how they can be valued. In particular, we examine what fixed-interest-rate payments will be traded for floating-rate payments in the market.
Structure of Interest-Rate Swaps
Debt contracts involve either fixed or floating interest rates. A floating-rate contract typically links the interest rate to a major market rate such as LIBOR. During the life of the floating-rate debt, the interest rate changes periodically to reflect changes in the market rate. In contrast, fixed-interest-rate contracts lock in a single interest rate for the duration of the loan. Fixed- and floating-rate contracts lead to very different interest-risk exposures for borrowers and lenders.
Consider a firm that has issued a three-year floating-rate debt instrument, where the floating rate is three-month LIBOR + 75 basis points (1 basis point equals 0.01%). While the firm knows the amount of its first interest payment (based on knowing the current level of LIBOR), the second and remaining interest payments will depend on future levels of LIBOR.
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Keywords: interest rates, swaps
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