We now move on to consider some examples of swaps where the simple rule “assume forward rates will be realized” does not work. In each case, it must be assumed that an adjusted forward rate, rather than the actual forward rate, is realized. This section builds on the discussion in Chapter 30.
A plain vanilla interest rate swap is designed so that the floating rate of interest observed on one payment date is paid on the next payment date. An alternative instrument that is sometimes traded is a LIBOR-in-arrears swap. In this, the floating rate paid on a payment date equals the rate observed on the payment date itself.
Suppose that the reset dates in the swap are for , with