Derivatives

CHAPTER 34Pricing Interest Rate Swaps

Aims

• To show that cash flows in a swap are equivalent to a replication portfolio consisting of a position in a fixed rate bond and a floating rate note (bond) (FRN).
• To demonstrate that the swap rate is calculated by assuming that the swap must have the same value to both parties at inception – otherwise the swap would not take place. The swap rate is determined solely by the term structure of interest rates.
• To show how arbitrage arguments can be invoked to demonstrate that the market value of an FRN is equal to the notional principal Q in the FRN (a) at inception , and (b) just after, any reset date .
• To show how to value an FRN at any date (between payment dates), using two different methods the ‘short method’ and the ‘forward rate method’. Both methods give the same outcome for the value of the FRN at any date .
• To show that the value of a swap at any date is the difference between the present value of the cash flows from a fixed rate bond and ...