Introduction to Fixed Income Analytics: Relative Value Analysis, Risk Measures, and Valuation, Second Edition

CHAPTER 16

Analysis of Interest Rate Swaps

An interest rate swap contract provides a vehicle for market participants to transform the nature of cash flows and the interest rate exposure of a portfolio or balance sheet. In this chapter we explain how to analyze interest rate swaps. We will describe a generic interest rate swap, the parties to a swap, the risk and return of a swap, and the economic interpretation of a swap. Then we look at how to compute the floating rate payments and calculate the present value of these payments. Next we will see how to calculate the fixed rate payments given the swap rate. Before we look at how to calculate the value of a swap, we will see how to calculate the swap rate. Given the swap rate, we will then see how the value of swap is determined after the inception of a swap. Since an interest rate swap can be used to control the interest rate risk of a portfolio or a balance, we will explain how to estimate a swap’s dollar duration. Swap markets help investors assess the relative value of a complicated security in two basic ways. First, the cash flows of a floater can be converted into a synthetic fixed rate security using swaps. Once transformed into a fixed rate security, its yield can then be compared to the yields on other comparable fixed rate instruments. Second, the cash flows of a complicated security can be converted into a synthetic fixed rate security using a combination of swaps and options. We will see how this is done in Chapter 15 ...