Lecture 8

Lecture 8.
Interest Rate Contracts & Swaps

Hedging exposure to interest rate movements
&
Introduction to Swaps
Options, Futures, Derivatives 10/01/07 back to start 1
Solution
Problem 3.23. The following table gives data on monthly changes in the spot price and the futures
price for a certain commodity. Use the data to calculate the minimum variance hedge ratio.
Spot price change +0.50 +0.61 -0.22 -0.35 +0.79
Futures price change +0.56 +0.63 -0.12 -0.44 +0.60
Spot price change +0.04 +0.15 +0.70 -0.51 -0.41
Futures price change -0.06 +0.01 +0.80 -0.56 -0.46
Solution, cont.
Solution: Let x
j
denote the change in the spot price and y
j
denote the change in the futures price.
Then x =
1
10
P
x
j
= 0.96 and y =
1
10
P
y
j
= 1.30. Then
x
=
s
P
x
2
j
9
0.96
2
10 9
= 0.5116
y
=
s
P
y
2
j
9
1.30
2
10 9
= 0.4933
For we have
=
10
P
x
j
y
j
P
x
j
P
y
j
r
10
P
x
2
j
0.96
2
10
P
y
2
j
1.30
2
= 0.981
Minimum hedge ratio is
F
= 0.981
0.4933
0.5116
= 0946
Solution
Problem 3.25. It is now October 2004. A company anticipates that it will purchase 1 million
pounds of copper in each of February 2005, August 2005, February 2006, and August 2006. The
company has decided to use the futures contracts traded in the COMEX division of the New York
Mercantile Exchange to hedge its risk. One contract is for the delivery of 25,000 pounds of copper.
The initial margin is $2,000 per contract and the maintenance margin is $1,500 per contract. The
companys policy is to hedge 80% of its exposure. Contracts with maturities up to 13 months into
the future are considered to have sucient liquidity to meet the companys needs. Devise a
hedging strategy for the company. Assume the market prices (in cents per pound) today and at the
future dates are as follows:
Date Oct. 2004 Feb. 2005 Aug. 2005 Feb. 2006 Aug. 2006
Spot Price 72.00 69.00 65.00 77.00 88.00
Mar. 2005 futures price 72.30 69.10
Sept. 2005 futures price 72.80 70.20 64.80
Mar. 2006 futures price 70.70 64.30 76.70
Sept. 2006 futures price 64.20 76.50 88.20
What is the impact of the strategy you propose on the price the company pays for copper? What
is the initial margin requirement in Oct. 2004? Is the company subject to margin calls?
Solution
Solution: To hedge the February 2005 purchase, the company should take a long position in March
2005 contracts for delivery of 800,000 pounds of copper. The total number of contracts required is
800,000/25,000 = 32. Similarly a long position in 32 September contracts is required to hedge the
August 2005 purchase. For the February 2006 purchase the company could take a long position in
32 September 2005 contracts and roll them into March 2006 contracts during August 2005.
(Or alternatively, hedge the Feb. 2006 purchase by taking a long position in 32 March 2005
contracts and rolling them into March 2006 contracts)
For the August 2006 purchase the company could take a long position in 32 September 2005 and
roll them into September 2006 contracts during August 2005. Therefore, we have
Oct. 2004: Enter into a long position in 96 Sept. 2005 contracts
Enter into a long position in 32 March 2005 contracts
Feb. 2005: Close out 32 March. 2005 contracts
Aug. 2005: Close out 96 Sept. 2005 contracts
Enter into long position in 32 Mar. 2006 contracts
Enter into long position in 32 Sept. 2006 contracts
Feb. 2006: Close out 32 Mar. 2006 contracts
Aug. 2006: Close out 32 Sept. 2006 contracts
Solution, cont.
With the market prices the company pays
69.00 + 0.8 (72.30 69.10) = 71.65
for copper in Feb. 2005. It pays
69.00 + 0.8 (72.80 64.80) = 71.40
for copper in August 2005. As far as the Feb. 2006 purchase is concerned, it loses 72.80-64.80
= 8.00 on the Sept. 2005 futures and gains 76.70-64.30 = 12.40 on the Feb. 2006 futures.
The net price paid is
77.00 + 0.8 8.00 0.8 12.40 = 73.48
As far as the Aug. 2006 purchase is concerned, it losees 72.80-64.80=8.00 on the Sept. 2005
futures and gains 88.20-64.20 = 24.00 on the Sept. 2006 futures. The net price paid is
88.00 + 0.8 8.00 0.8 24.00 = 75.20
The hedging scheme succeeds in keeping the price paid in the rage 71.40 to 75.20. In Oct.
2004 the initial margin requirement on the 128 contracts is 128 $2, 000 or $256,000. There
is a margin call when the futures price drops by more than 2 cents. This happens to the March
2005 contract between Oct. 2004 and Feb. 2005, to the Sept. 2005 contract between Oct.
2004 and Feb. 2005, and to the Sept. 2005 contract between Feb. 2005 and August 2005.
Solutions
Problem 4.23. An interest rate is quoted as 5% per annum with semiannual compounding. What
is the equivalent rate with (a) annual compounding, (b) monthly compounding, and (c) continuous
compounding?
Solution Rates are
`
1 +
r
m
m
for m-times compounding, so
a. Annual compounding we have
`
1 +
5
2
2
= (1 +r) or
r = 1.025
2
1 = 0.050625 = 5.063%
b. Month compounding we have
`
1 +
5
2
2
=
`
1 +
r
12
12
or
12
1.025
1
6
1
= 0.04949 = 4.949%
c. Continuous compounding we have
`
1 +
5
2
2
= e
r
or
2 ln 1.025 = 0.04939 = 4.939%
Eurodollar Futures
The most popular interest rate futures contract in the US is the 3-month Eurodollar futures
contract traded on CME.
A eurodollar is a dollar deposited in a US or foreign bank outside the US.
The Eurodollar interest rate is the rate of interest earned on Eurodollars deposited by one bank
with another bank.
Essentially the same as the LIBOR (London Interbank Oer Rate)
3-month Eurodollar futures contracts are contracts on the 3-month Eurodollar interest rate
Allow for investors to lock in an interest rate on $1 million for a future 3-month period.
Delivery months of March, June, September, December for up to 10 years into the future
In other words, an investor in 2007 can use Eurodollar futures to lock in an interest rate for
3-month periods that are as far into the future as 2017.
Eurodollar Futures, cont.
Consider a March 2005 contract.
Settlement price is 97.63 and the contract ends on the third Wednesday of the delivery month
= March 16, 2005.
The contract is marked to market in the usual way until this date.
On March 16, 2005 the settlement price is set equal to 100 R, where R is the actual
3-month Eurodollar interest rate on that day, expressed with quarterly compounding and an
actual/360 day count convention
In particular if the 3-month Eurodollar interest rate on March 16, 2005, turned out to be 2%,
the nal settlement price would be 98.
Final marking to market to reect this settlement price and all contracts are declared closed
Remarks:
Contract designed so that each basis point (0.01%) results in a gain/loss of $25 for each
long/short contract. One basis point up results in a gain of $25 for the long and a loss of $25
for the short. One basis point down results in loss of $25 for the long and a gain of $25 for the
short since
1, 000, 000 0.0001
1
4
= 25
Since the futures quote is 100 minus the futures interest rate, an investor who is long gains
when the interest rates fall and an investor who is short gains when interest rates rise.
Eurodollar, cont.
The exchange denes the contract price as
10, 000 (100 0.25 (100 Q))
where Q is the quote. The settlement price of 97.63 for the March 2005 contract
corresponds to a contract price of
10, 000 (100 0.25 (100 97.63)) = $994, 075
If the nal contract price is
10, 000 (100 0.25 (100 98)) = $995, 000
Dierence between the initial and nal contract price is $925, so the investor with
the long position in 5 contracts gains 5 925 = $4, 625.
Forward vs. Futures Interest Rates
Eurodollar futures lock in an interest rate for a future period
For short maturities, the rates can be assume to be the same as a forward interest rate
agreement (FRA)
Recall: FRA is an OTC agreement that a certain interest rate will apply to either borowing or
lending a certain principal during a specied period of time.
Longer contracts have signicant dierences. Consider contracts between T
1
and T
2
Eurodollar futures are settled daily with nal settlement price at T
2
the realized interest rate
from the entire span of settlements
FRAs are settled once at the end time T
2
with the realized interest rate between the two
times T
1
and T
2
.
Forward vs. Futures Interest Rates, cont.
Two important distinctions between FRAs and Interest Rate Futures:
Dierence between Eurodollar futures contract and a similar contract with no daily settlement
(a forward contract with a payo equal to the dierence between the forward interest rate and
the realized interest rate paid at time T
1
)
Dierence between a forward contract with settlement at T
1
vs. settlement at T
2
.
Both distinctions depress the forward rate relative to the futures rate.
Consider the rst case:
Suppose there is a contract with payo R
M
R
F
at time T
1
with R
F
a predetermined rate
for the period between T
1
and T
2
. R
M
is the realized rate.
Suppose we can switch to daily settlement then
Daily settlement leads to cash inows when rates are high and outows when rates are low.
Switching is attractive since more money in the margin account. when rates are high.
In response the market would set R
F
higher for the daily settlement alternative.
In other words, switching from daily settlement to settlement at time T
1
reduces R
F
.
Forward vs. Futures Interest Rates
Consider the second case:
Let R
F
be the predetermined rate for the period between T
1
and T
2
Let R
M
be the realized rate for this period.
Suppose the payo is R
M
R
F
at time T
2
. If R
M
is high, the payo is positive. Because
rates are high, the cost to you of having the payo that you receive at time T
2
rather than T
1
is relatively high.
If R
M
is low, the payo is negative. Because the rates are low, the cost to you of having the
payo that you receive at time T
2
rather than T
1
is relatively low.
Overall you would rather have the payo at time T
1
. If the payo is at time T
2
then there
should be compensation by reduction in R
F
.
To compensate, analysts use convexity adjustment to account for the dierences in the two rates.
A common model is
Forward rate = Futures rate
2
2
T
1
T
2
where T
1
is the time to maturity of the futures contract and T
2
is the time maturity of the rate
underlying the futures contract. is the standard deviation of the change in the short-term
interest rate in 1 year. Both rates are expressed with continuous compounding.
Example, of Convexity Adjustment
Suppose = 0.012 (a typical value) and wish to calculate the forward rate when the 8-year
Eurodollar futures price quote is 94.
T
1
= 8 and T
2
= 8.25 and convexity adjustment is
1
2
0.012
2
8 8.25 = 0.00475 or
47.5 basis points.
Futures rate is 6% per annum on actual/360 basis with quarterly compounding or
365
90
ln
`
1 +
6
4
= 6.038% continuously compounded.

The forward rate estimate is
R
F
= 6.038 0.475 = 5.563%
per annum with continuous compounding.
Using Eurodollar Futures to Extend the LIBOR Zero Curve
The LIBOR zero-curve is determined by the 1-month, 3-month, 6-month, and 12-month LIBOR
rates. Once convexity adjustments have been made, Eurodollar futures are often used to extend
the zero curves.
Assume that the forward interest rate calculated from the ith futures contract applies exactly to
the period T
i
to T
i+1
. We bootstrap at this point. Recall that forward interest rates R
i
are
calculated via:
R
F
=
R
2
T
2
R
1
T
1
T
2
T
1
If F
i
is the forward rate calculated from the ith Eurodollar futures contract and R
i
is the zero rate
for the maturity T
i
then
F
i
=
R
i+1
T
i+1
R
i
T
i
T
i+1
T
i
Hence, solving for R
i+1
yields
R
i+1
=
F
i
(T
i+1
T
i
) +R
i
T
i
T
i+1
Extending the LIBOR Zero Curve, example
Example: Suppose the 400-day LIBOR zero rate is 4.80% with cont. compounding.
From Eurodollar futures quotes, the forward rate for 90-day period beginning in 400 days is
5.30% with cont. compounding
Forward rate for 90-day period beginning in 491 days is 5.50% with cont. compounding
Forward rate for 90-day period beginning in 589 days is 5.60% with cont. compounding
The 491-day rate is
R =
F
i
T +R
i
F
i
T
i+1
=
0.053 91 + 0.048 400
491
= 4.893%
Second forward rate is
R =
F
i
T +R
i
F
i
T
i+1
=
0.055 98 + 0.04893 491
589
= 4.994%
Third forward rate is
R =
F
i
T +R
i
F
i
T
i+1
=
0.056 91 + 0.04994 589
680
= 5.075%
if the next 90-day period ends on day 680.
Duration-Based Hedging Strategies
F
C
Contract price for the interest rate futures contract
D
F
Duration of the asset underlying the futures contract
at the maturity of the futures contract
P Forward value of the portfolio being hedge
at the maturity of the hedge
D
P
Duration of the portfolio at the maturity of the hedge
Let y be the change in the yield, and assume the change is the yield for all maturities. Then
P = PD
P
y
Assume further that
F
C
= F
C
D
F
y
The number of contracts (called the duration-based hedge ratio) is:
N
=
PD
P
F
C
D
F
Financial institutions attempt to hedge against interest rates risk by ensuring that average
duration of their assets equals the average duration of their liabilities
This is called duration matching or portfolio immunization
Duration-Based Hedging, cont.
Example:
August 2 and fund manager with $10 million invested in government bonds is concerned that
interest rates are expected to be highly volatile over the next 3 months. The fund manager
decides to use the December T-bond futures contract to hedge the value of the portfolio.
The current futures price is 93-02 = 93.0625. Each contract for delivery of $100,000 bonds,
therefore, has a futures contract price of $93,062.50.
Suppose the duration of the bond portfolio in 3 months will be 6.80 years. The
cheapest-to-deliver bond in the T-bond is expected to be a 20-year 12% per annum coupon
bond.
The yield on this bond is 8.80% per annum, and the duration will be 9.20 years at maturity of
the futures contract.
Fund manager requires a short position in T-bond futures to hedge the bond portfolio. If
interest rates increase, a gain will be made on the short futures position, but a loss will be
made on the portfolio.
If interest rates decrease, a loss will be made on the short position, but a gain will be made on
the portfolio.
N
=
10, 000, 000
93, 062.50
6.80
9.20
= 79.42
Summary
A short position in Treasury bond futures contracts allows the party to
Delivery on any day during the delivery month
Delivery a number of alternative bonds
On any day during the delivery month, a notice of intention to delivery up to 8PM using the
2PM settlement price.
Eurodollar futures contract is a 3-month rate on the third Wednesday of the delivery month.
Eurodollar futures are used to estimate LIBOR forward rates in order to construct the LIBOR
zero-curve.
Duration is useful to hedge interest rate risk. Enable hedger to assess the sensitivity of a bond
portfolio to small parallel shifts in the yield curve.
Swaps
A swap is an agreement between two companies to exchange cash ows in the future.
An agreement includes the dates when the cash ows are paid and the way in which they are
calculated.
Most common swap is a plain vanilla swap: One company agrees to pay cash ows equal to
interest at a predetermined xed rate on a notional principal for a number of years.
In return, the other company pays interest at a oating rate on the same notional principal for
the same period of time.
Most common oating rate is the LIBOR. Typically 1-month, 3-month, 6-month, and 12-month
rates.
Example: Consider 5-year bond with a rate of interest specied as 6-month LIBOR plus 0.5% per
annum.
Life the the bond is divided into 10 6-month periods.
Each period has a rate of interest set at 0.5% per annum above the 6-month LIBOR rate at the
beginning of the period.
Interest is paid at the end of the period.
In depth Example, swap
Consider a 3-year swap initiated on March 5, 2004 between Microsoft and Intel.
Microsoft pays Intel an interest rate of 5% per annum on a notional principal of $100 million.
(xed-rate payer)
Intel pays Microsoft the 6-month LIBOR rate on the same notional principal. (oating-rate
payer)
Payments are exchanged every 6 months with 5% interest rate compounded semiannually.
First payment exchange takes place on Sept. 5, 2004, 6-months after initiation. Microsoft pays
Intel $2.5 million. Intel would pay interest at the 6-month LIBOR rate prevailing 6-months prior
to Sept. 5, 2004 (March 5, 2004).
If the 6-month LIBOR rate on Mar. 5, 2004 is 4.2%, then Intel pays Microsoft
0.5 0.042 $100, 000, 000 = $2.1million
In depth Example, swap
Second payment exchange takes place on Mar. 5, 2005, 12 months after initiation. Microsoft
pays Intel $2.5 million. Intel would pay interest at the 6-month LIBOR rate prevailing 6-months
prior to Mar. 5, 2005 (Sept. 5, 2004).
If the 6-month LIBOR rate on Mar. 5, 2004 is 4.8%, then Intel pays Microsoft
0.5 0.048 $100, 000, 000 = $2.4 million
In sum over 6 payments satisfying:
Date Six Month Floating cash Fixed cash Net cash
LIBOR rate ow received ow paid ow
Mar. 5, 2004 4.20
Sept. 5, 2004 4.80 +2.10 -2.50 -0.40
Mar. 5, 2005 5.30 +2.40 -2.50 -0.10
Sept. 5, 2005 5.50 +2.65 -2.50 +0.15
Mar. 5, 2006 5.60 +2.75 -2.50 +0.25
Sept. 5, 2006 5.90 +2.80 -2.50 +0.30
Mar. 5, 2007 +2.95 -2.50 +0.45
Swaps, cont.
Notional Principal is not exchanged.
Since principal is not exchanged, then the swap can be viewed as an exchange
of:
xed-rate bond oating-rate bond
Swaps and Liabilities (Loans)
Swaps can change the nature of loans.
In our example Microsoft can use the swap to transform a oating-rate loan into a xed-rate loan.
Suppose Microsoft has borrowed $100 million at LIBOR plus 10 basis points. Then Microsoft
pays LIBOR plus 0.1% to its outside lender
earns LIBOR under the terms of the swap
pays 5% under terms of the swap
In total Microsoft pays xed interest payments of 5.1%
Swaps and Liabilities (Loans), cont.
In our example Intel can use the swap to transform a xed-rate loan into a oating-rate loan.
Suppose Intel has a 3-year $100 million loan with a xed 5.3% interest rate. Then Intel
pays 5.3% to its outside lender
pays LIBOR under the terms of the swap
earns 5% under the terms of the swap
In total Intel pays a LIBOR plus 30 basis points.
Swaps and Assets
Swaps can change the nature of assets.
The swap can change an asset earning a xed rate of income into an asset that earns a oating
rate of interest. Suppose Microsoft owns $100 million in bonds that will earn 4.7% interest per
annum over 3 years. After the swap it
earns 4.7% on the bonds
earns LIBOR under the terms of the swap
pays 5% under the terms of the swap
In total Microsoft earns LIBOR minus 30 basis points.
Swaps and Assets, cont.
The swap can change an asset earning a oating rate of income into one earning a xed rate of
income. Suppose Intel owns an investment of $100 million that will earn LIBOR minus 20 basis
points. After the swap it
earns LIBOR minus 20 basis points on the investment
pays LIBOR under the terms of the swap
earns 5% under the terms of the swap
In total Intel earns 4.8% on the $100 million investment per annum.
Role of Financial Intermediary
Non-nancial companies usually do not get in touch with each other to arrange swaps.
Rather companies deal through a nancial intermediary.
Plain-vanilla xed-point swaps are structured so that nancial institutions earn about 3 or 4
basis points on a pair of osetting transactions per year.
In our example, the nancial company setting up the Intel-Microsoft swap would expect to make
0.0003 100 million = $30,000 per year.
Half of the proceeds from each company.
Microsoft would borrow at 5.115% instead of at 5.1%.
Intel would borrow at LIBOR plus 21.5 basis points instead of LIBOR plus 20 basis points.
Market Makers
Many large nancial institutions act as market makers for swaps, since unlikely that two companies
have completely compatible needs.
Bid / Oer / Swap rates, percent per annum
Maturity Bid Oer Swap rate
2 6.03 6.06 6.045
3 6.21 6.24 6.225
4 6.35 6.39 6.370
5 6.47 6.51 6.490
7 6.65 6.68 6.665
10 6.83 6.87 6.850
Bid/Oer rates dier by 3 to 4 basis points. Average of bid and oer rates is the swap rate.
B
fix
Value of xed-rate bond underlying the swap
B
fl
Value of oating-rate bond underlying the swap
Swaps have zero value, so B
fix
= B
fl
.
Day Count Issues
Day count conventions will aect payments of swaps
A LIBOR -based oating-rate cash ow on swap payment is calculated as
LRn
360
where L is the principal, R is the relevant LIBOR rate, and n is the number of
days since the last payment date.
Ignore for now.
Conrmations
A conrmation is the legal agreement underlying a swap.
Signed by representatives of the two parties.
Conrmations
Comparative Advantage
Companies may have trouble accessing good xed rate or oating rate loans, depending on their
credit rating. Swaps allow for the company to convert xed-rate loans from oating depending on
its needs.
Credit rating describes likelihood of a company defaulting on a loan. S&P ratings go AAA, AA, A,
BBB, BB, B, CCC. LIBOR is the rate at which AA-rated banks borrow for periods between 1 and
12 months.
Example: Consider two companies AAACo and BBBCo, both wish to borrow $10 million for 5
years and have been oered rates
Fixed Floating
AAACo 4.0 % 6-month LIBOR +0.3%
BBBCo 5.2% 6-month LIBOR +1.0%
BBBCo has a worse credit rating, so it borrows at a higher rate. Wants a xed-rate loan.
AAACo has a better credit rating, so it borrows at a cheaper rate. Wants a oating-rate loan.
Dierence in xed-rate = 1.2% whereas dierence in oating-rate = 0.7%.
BBBCo seems to have a comparative advantage in oating-rate markets
AAACo seems to have a comparative advantage in xed-rate markets
Dierence leads to a swap negotiation
Comparative Advantage, cont.
AAACo borrows xed-rate funds at 4% per annum
BBBCo borrows oating-rate funds at LIBOR plus 1% per annum
Assume direct negotiation. AAACo agrees to pay BBBCo interest at 6-month LIBOR on $10
million. In return BBBCo agrees to pay AAACo interest at a xed rate of 3.95% per annum on
$10 million.
AAACo
pays 4% per annum to outside lenders
receives 3.95% per annum from BBBCo
pays LIBOR to BBBCo
Net eect for AAACo is AAACo pays LIBOR plus 0.05% per annum or 0.25% less than direct
lending.
BBBCo
pays LIBOR plus 1% per annum to outside lenders
receives LIBOR from AAACo
pays 3.95% per annum to AAACo
Net eect for BBBCo is BBBCo pays 4.95% per annum. This is 0.25% less than direct lending.
This swap is structured so that net gain is same for both parties. Here we take the dierence of
the xed-rate = 1.2% and dierence of oating rate = 0.7%. Then the dierence between the
two dierences is 0.5%. The gain is split evenly.
Comparative Advantage, cont.
Suppose there is a nancial intermediary: Then AAACo borrows at LIBOR +
0.07% and BBBCorp borrows at 4.97%. Financial company earns 0.04% per
year.
The gain for both borrowing companies is 0.23% per year. Total gain to all
parties is 0.50% (including the nancial intermediary.
Criticism of Comparative-Advantage Argument
Should have been arbitraged away? Important points:
Fixed-rate interest rates are 5-year years
LIBOR plus ... are oating-rate 6-month rates
In oating rate market, every 6 months the lender has the opportunity to review the credit
rating of the company. If the credit rating plummets, then the lender can increase the spread
over LIBOR. Can even refuse to roll over loan.
Spreads also reect the chance of default over the period.
In the 6-month period, rather unlikely for either company to default.
Over the 5-year period, much more likely for BBBCo to default.
If BBBCo starts at LIBOR +1% and the credit rating drops so the loan rolls over to a rate of
LIBOR +2% then the rate increases to 5.97%. On the other hand the xed rate would not
change.
Swap Rates
Recall swap rate is the average of
the xed rate that a swap market maker is prepared to pay in exchange for receiving LIBOR
(bid)
the xed rate that it is prepared to receive in return for paying LIBOR (oer)
Swap rates are nearly risk free.
A nancial institute can earn the 5-year swap rate by
Lending the principal for the rst 6 months to a AA-borrower and then relend it for successive
6-month periods to other AA-borrowers
Enter into a swap to exchange the LIBOR income for the 5-year swap rate.
In other words 8-year swap rate is an interest rate with credit risk corresponding to 16 consecutive
6-month LIBOR loans to AA companies.
Swap rates are less than AA borrowing rates since more attractive to lend money for short periods
of time (6-month) than for long periods of time to retain liquidity.
Determining Swap/Zero Rates
Use of LIBOR rates as risk-free rates used to price futures contracts.
Only know LIBOR rates up to 12-month period.
Extend LIBOR rates past 12 months via Eurodollar futures (up to 5 years, usually)
Traders use swap rates to extend LIBOR zero curve further. Called the LIBOR/Swap zero curve.
How to determine the curve:
New oating-rate bond is always equal to its principal value (par value) when using
LIBOR/Swap zero curve for discounting. (Since rate of interest is LIBOR and LIBOR is
discount rate)
Next B
fl
= B
fix
for a new swap where xed rate equals swap rate (again at start). This
implies both B
fl
and B
fix
equal the notional principal.
Together imply that swap rates dene a par yield bond.
Use bootstrap argument.
Determining Swap/Zero Rates
Example:
Suppose that 6-month, 12-month, 18-month LIBOR/swap zero rates have been determined as
4%, 4.5%, and 4.8% with continuous compounding
The 2-year swap rate (with semiannual payments) is 5%.
The 5% swap rate means, bond with principal of $100 and a semiannual coupon of 5% per
annum sells for par.
If R is the 2-year zero rate then
2.5e
0.040.5
+ 2.5e
0.0451.0
+ 2.5e
0.0481.5
+ 102.5e
2R
= 100
Solving for R yields R = 4.953%.
Valuation
Principal is not exchange in swap agreements.
In valuing swaps helpful to think of the principal as being exchanged. Then from the perspective of
the oating-rate payer, a swap can be regarded as a long position in xed rate bond and short
position in oating rate bond. Yields a swap value of
V
swap
= B
fix
B
fl
where B
fl
is the value of the oating-rate bond and B
fix
is the value of the xed-rate bond.
From the perspective of the xed-rate payer, a swap can be regarded as a short position in xed
rate bond and long position in oating rate bond. Yields a swap value of
V
swap
= B
fl
B
fix
Note that a bond is worth the notional interest immediately after interest payment, since LIBOR
has just been rolled-over and fair market value has been issued.

Lecture 8

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Lecture 8

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Lecture 8.

Interest Rate Contracts & Swaps

= 6.038% continuously compounded.

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