Fixed Income Securities, 4th Edition

CHAPTER 2Swap, Spot, and Forward Rates

Chapter 1 showed that discount factors fully describe the time value of money as embedded in market prices. Investors and traders, however, often find it more intuitive to quote the time value of money in terms of interest rates and, in particular, in terms of either swap rates or par rates, spot rates, and forward rates.

This chapter begins by explaining that interest rates are always quoted as annual rates, that interest is conceptualized as being paid over a number of periods of fixed length (e.g., 90 days, three semiannual periods), and that interest rate quotations indicate the payment of either simple or compound interest. The chapter then introduces interest rate swaps (IRS) as context for the material. Swaps and bonds together comprise a significant portion of fixed income markets, and swaps, because they are relatively liquid, have become benchmarks against which to evaluate other fixed income instruments.

At the time of this writing, interest rate swap markets are in transition away from LIBOR (London Interbank Offered Rate), which has dominated floating‐rate indexes for decades. Chapter 12 discusses this transition, but this chapter briefly introduces the leading candidates for replacing LIBOR (e.g., Secured Overnight Financing Rate (SOFR) in the United States) and their associated swaps. Chapter 13 discusses why and how market participants use interest rate swaps.

2.1 INTEREST RATE QUOTATIONS

An investment with fixed cash ...