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Glenn Shafer
Glenn Shafer
Valuation of a Swap
A plain-vanilla swap can be thought of in two
different ways, which lead to two different ways
of valuing them:
You are swapping a bond with fixed-rate
payments for a bond with floating-rate
payments.
The fixed-rate bond can be valued as in the
preceding chapter, discounting each coupon
payment using the zero-coupon rate for its date.
The floating-rate bond has its face value as its
present value, immediately after the payment of
a coupon.
Glenn Shafer
Glenn Shafer
Example 5.1
Bank has agreed to pay 6-month LIBOR and
receive 8% (semiannual) on $100 million.
Remaining life: 1.25 years.
LIBOR (continuous)
10% for 3 months
10.5% for 9 months
11% for 15 months.
The LIBOR 6-month rate at the last payment date
(3 months ago) was 10.2% (semiannual)
What is the value of the swap?
Value of swap is
98.24 102.51 = $4.27 million
Glenn Shafer
Problem 5.19
Under the terms of an interest rate swap, a financial
institution has agreed to pay 10% per annum and to
receive three-month LIBOR in return on a notional
principle of $100 million with payments being
exchanged every three months.
The swap has a remaining life of 14 months.
The average of the bid-ask fixed rate currently
being swapped for three-month LIBOR is 12% per
annum.
All rates are compounded quarterly.
The three-month LIBOR one month ago was
11.8% per annum (quarterly compounding).
What is the value of the swap?
Hint:
Convert the 12% to continuous compounding (this
gives 11.82%) and use it as the LIBOR of all
maturities to discount the future payments for both
the fixed and floating rate bonds.
But of course the 3-month LIBOR one month ago
defines the payment on the floating rate bond one
month from now.