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Interest Rate Swaps and Swap Valuation

Introduction

An interest rate swap is a contractual agreement between two counterparties to exchange cash flows on particular dates in the future. There are two types of legs (or series of cash flows). A fixed rate payer makes a series of fixed payments and at the outset of the swap, these cash flows are known. A floating rate payer makes a series of payments that depend on the future level of interest rates (a quoted index like LIBOR for example) and at the outset of the swap, most or all of these cash flows are not known. In general, a swap agreement stipulates all of the conditions and definitions required to administer the swap including the notional principal amount, fixed coupon, accrual methods, day count methods, effective date, terminating date, cash flow frequency, compounding frequency, and basis for the floating index.

An interest rate swap can either be fixed for floating (the most common), or floating for floating (often referred to as a basis swap). In brief, an interest rate swap is priced by first calculating the present value of each leg of the swap (using the appropriate interest rate curve) and then aggregating the two results.

An FX swap is where one leg's cash flows are paid in one currency while the other leg's cash flows are paid in another currency. An FX swap can be either fixed for floating, floating for floating, or fixed for fixed. In order to price an FX swap, first each leg is present valued in its currency (using the appropriate curve for the currency).

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Technical Details

To value a swap, the present value of cash flows of each leg of the transaction must be determined. In an interest rate swap, the fixed leg is fairly straightforward since the cash flows are specified by the coupon rate set at the time of the agreement. Valuing the floating leg is more complex since, by definition, the cash flows change with future changes in the interest rates.

Several risk statistics are calculated for interest rate swaps including modified duration, convexity, and basis point value. These swap risk statistics are based on the risk statistics for the individual legs of the swap.

Analysis Supported

FINCAD interest rate swap functions can be used for the following:

  • Generic interest rate swaps, allows custom structure (variable notional, variable fixed leg coupon)
  • Cross-currency and basis swaps
  • % LIBOR swaps
  • Non-generic interest rate swaps
  • Fixed legs
  • Floating Rate Notes

To evaluate the FINCAD solutions to value various interest rate swaps, contact a FINCAD Representative.

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