Pricing Interest Rate Swaps

Pricing Interest Rate Swaps.

If we consider the generic fixed-to-floating interest rate swap, the most obvious difficulty to be overcome in pricing such a swap is the fact that the future stream of floating rate payments to be made by one counterparty is unknown at the time the swap is being priced.

This must be literally true: no one can know with absolute certainty what the 6 month US dollar Libor rate will be in 12 months time or 18 months time.

However, if the capital markets do not possess an infallible crystal ball in which the precise trend of future interest rates can be observed, the markets do possess a considerable body of information about the relationship between interest rates and future periods of time.

In many countries, for example, there is a deep and liquid market in interest bearing securities issued by the government. These securities pay interest on a periodic basis, they are issued with a wide range of maturities, principal is repaid only at maturity and at any given point in time the market values these securities to yield whatever rate of interest is necessary to make the securities trade at their par value.

It is possible, therefore, to plot a graph of the yields of such securities having regard to their varying maturities. This graph is known generally as a yield curve -- i.e.: the relationship between future interest rates and time -- and a graph showing the yield of securities displaying the same characteristics as government securities is known as the par coupon yield curve.

The classic example of a par coupon yield curve is the US Treasury yield curve.

A different kind of security to a government security or similar interest bearing note is the zero-coupon bond. The zero-coupon bond does not pay interest at periodic intervals.

Instead it is issued at a discount from its par or face value but is redeemed at par, the accumulated discount, which is then repaid representing compounded or "rolled-up" interest.

A graph of the internal rate of return (IRR) of zero-coupon bonds over a range of maturities is known as the zero-coupon yield curve.

Reference Pages

Profit from Interest Rate Swaps

Compararative Advantage

Fixed Rate Debt