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- 1. Understanding Interest Rate Swap By: Rohan Byanjankar 7/29/2017 By: Rohan Byanjankar 1
- 2. Interest Rate Swap • Interest Rate Swap is one the types of Swap Contract in which two parties with equal principal amount called notional principal agrees to exchange their cash flow for a specified period of time. • Two parties can either enter into interest rate swap contract: • To exchange fixed and floating interest cash flows, which is called Plain Vanilla Swap • To exchange both floating interest cash flows, which is called Basis Swap 7/29/2017 By: Rohan Byanjankar 2
- 3. Price of Swap • The price of a swap is the coupon rate that makes the fixed rate bond to have a value equal to that of the floating rate bond, and thus causes the initial swap value to equal zero. 7/29/2017 By: Rohan Byanjankar 3
- 4. Pricing of Swap • Price of Swap = 1 q × 1−𝑃𝑉𝐼𝐹(𝑛) 1 n PVIF(i) • Where, • q = Adjustment Factor • PVIF(n) = Present Value factor of nth term • 1 n PVIF(i) = Sum of Present Value factor of all ith term, where i tends to 1 to n. 7/29/2017 By: Rohan Byanjankar 4
- 5. Value of Swap • Value of Swap is the net gain or loss to the parties involved in swap contract. • It is the difference between present value of two streams of cash flow. • Value of Swap is obtained by calculating the difference between Value of Floating Rate Bond and Value of Fixed Rate Bond. 7/29/2017 By: Rohan Byanjankar 5
- 6. Value of Plain Vanilla Swap Plain Vanilla Swap • If a party is paying fixed rate and receiving floating rate, then • Value of Swap (Vs) = Value of Floating Rate Bond (V(FLRB)) - Value of Fixed Rate Bond (V(FXRB)) • If Vs>0, Party receiving fixed rate is in loss • If Vs<0, Party receiving floating rate is in loss. 7/29/2017 By: Rohan Byanjankar 6
- 7. Value of Floating Rate Swap V FLRB = Principal + Interest × PVIF(1) V(FLRB) = NP + NP × R FL × q × PVIF(1) Here, NP = Notional Principal R(FL) = Floating Interest Rate NP × R FL × q = Interest (I) PVIF(1) = Present Value factor of 1st term 7/29/2017 By: Rohan Byanjankar 7 Value of Plain Vanilla Swap
- 8. Value of Fixed Rate Swap V(FXRB) = Sum of Present Value of Interest + Present Value of Face Value or NP V FXRB = NP × R FX × q × 1 n PVIF(i) + NP × PVIF n Here, R(FX) = Fixed Rate of Bond 7/29/2017 By: Rohan Byanjankar 8 Value of Plain Vanilla Swap
- 9. Spread = Price of LIBOR Swap – Price of T_Bill Rate Swap Note: Spread is either deducted from LIBOR or is added to T-Bill Rate while calculating Value of Basis Swap 7/29/2017 By: Rohan Byanjankar 9 Spread in Basis Swap
- 10. 7/29/2017 By: Rohan Byanjankar 10 Value of Basis Swap Basis Swap • If a party is paying T-bill rate and receiving LIBOR, then • Value of Swap (Vs) = Value of LIBOR Floating Rate Bond (VL(FLRB)) - Value of T-Bill Floating Rate Bond (VT(FXRB)) • If Vs>0, Party receiving T-bill rate is in loss • If Vs<0, Party receiving LIBOR is in loss.
- 11. 7/29/2017 By: Rohan Byanjankar 11 Value of LIBOR Rate Swap VL FLRB = Principal + Interest × PVIF(1) VL(FLRB) = NP + NP × (R LFL − Spread) × q × PVIF(1) Here, NP = Notional Principal R(LFL) = Original LIBOR Floating Interest Rate of 1st Term NP × R FL × q = Interest (I) PVIF(1) = Present Value factor of 1st term Value of Basis Swap
- 12. 7/29/2017 By: Rohan Byanjankar 12 Value of T-bill Rate Swap VT FLRB = Principal + Interest × PVIF(1) VT(FLRB) = NP + NP × R TFL × q × PVIF(1) Here, NP = Notional Principal R(TFL) = Original T-Bill Floating Rate of 1st Term NP × R FL × q = Interest (I) PVIF(1) = Present Value factor of 1st term Value of Basis Swap

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