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BOND MATH: The Theory Behind the Formulas by Donald J. Smith

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Pricing an Interest Rate Swap

Figure 8.1 portrays an interest rate swap in the customary box-and-arrow format. Party A and Party B agree to exchange an interest rate that varies from period to period, specifically 3-month LIBOR (hence, it's the “floating” rate), for a fixed rate of 3.40% on a quarterly basis for two years. Net settlement payments are in arrears, meaning 3-month LIBOR is determined at the beginning of the period and then a payment for the rate difference, times the notional principal, times the fraction of the year, is made at the end of the period. Importantly, there is no exchange of principal at initiation or at maturity. That's why the principal is merely “notional”—it's the scale factor for the transaction.

Party A, the fixed-rate ...

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