Pricing and Valuation of Interest Rates and Other Swaps
Refresher reading access
Introduction
Swap contracts were introduced earlier as a firm commitment to exchange a series of cash flows in the future. Interest rate swaps in which fixed cash flows are exchanged for floating payments are the most common type. Subsequent lessons addressed the pricing and valuation of forward and futures contracts across the term structure, which form the building blocks for swap contracts.
In this lesson, we will explore how swap contracts are related to these other forward commitment types. Although financial intermediaries often use forward rate agreements or short-term interest rate futures contracts to manage interest rate exposure, issuers and investors usually prefer swap contracts, because they better match rate-sensitive assets and liabilities with periodic cash flows, such as fixed-coupon bonds, variable-rate loans, or known future commitments. It is important for these market participants not only to be able to match expected future cash flows using swaps but also to ensure that their change in value is consistent with existing or desired underlying exposures. The following lessons compare swap contracts with forward contracts and contrast the value and price of swaps.
Learning Outcomes
- describe how swap contracts are similar to but different from a series of forward contracts, and
- contrast the value and price of swaps.
Summary
- A swap contract is an agreement between two counterparties to exchange a series of future cash flows, whereas a forward contract is a single exchange of value at a later date.
- Interest rate swaps are similar to forwards in that both contracts are firm commitments with symmetric payoff profiles and no cash is exchanged at inception, but they differ in that the fixed swap rate is constant, whereas a series of forward contracts has different forward rates at each maturity.
- A swap is priced by solving for the par swap rate, a fixed rate that sets the present value of all future expected floating cash flows equal to the present value of all future fixed cash flows.
- The value of a swap at inception is zero (ignoring transaction and counterparty credit costs). On any settlement date, the value of a swap equals the current settlement value plus the present value of all remaining future swap settlements.
- A swap contract’s value changes as time passes and interest rates change. For example, a rise in expected forward rates increases the present value of floating payments, causing a mark-to-market (MTM) gain for the fixed-rate payer (floating-rate receiver) and an MTM loss for the fixed-rate receiver (floating-rate payer).
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