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This is the third in a series of articles that will go from the basics about interest rate swaps, to how to value them and how to build a zero curve.
- Introduction to Interest Rate Swaps
- Fixed legs
- Floating legs
- Swap Curve building Part I
- Swap Curve building Part II
Interest Rate Swap Example
For our example swap we will be using the following inputs:
- Notional: $1,000,000 USD
- Coupon Frequency: Semi-Annual
- Fixed Coupon Amount: 1.24%
- Floating Coupon Index: 6 month USD LIBOR
- Business Day Convention: Modified Following
- Fixed Coupon Daycount: 30/360
- Floating Coupon Daycount: Actual/360
- Effective Date: Nov 14, 2011
- Termination Date: Nov 14, 2016
- We will be valuing our swap as of November 10, 2011.
In the previous article we generated our schedule of coupon dates and calculated our fixed coupon amounts.
Calculating Forward Rates
To calculate the amount for each floating coupon we do the following calculation:
Floating Coupon = Forward Rate x Time x Swap Notional Amount
Where:
Forward Rate = The floating rate determined from our zero curve (swap curve)
Time = Year portion that is calculated by the floating coupons daycount method.
Swap Notional = The notional amount set in the swap confirmation.
In the next couple articles we will go through the process of building our zero curve that will be used for the swap pricing. In the meantime we will use the following curve to calculate our forward rates and discount our cashflows.
The numbers at each date reflect the time value of money principle and reflect what $1 in the future is worth today for each given date.
Let's look at our first coupon period from Nov 14, 2011 to May 14, 2012. To calculate the forward rate which is expressed as a simple interest rate we use the following formula:
where:
Solving for R
In our example we divide the discount factor for May 14, 2012 by the discount factor for Nov 14, 2011 to calculate DF.
0.9966889 / 0.9999843 = 0.9967046
T is calculated using Actual/360. The number of days in our coupon period is 182. 182/360 = 0.505556
R = (1 - 0.9967046) / (0.9967046 x 0.505556) = 0.654%
Our first coupon amount therefore is:
Floating Coupon = Forward Rate x Time x Swap Notional Amount
$ 3,306.33 = 0.654% x 0.505556 x $1,000,000
Below is a table with our forward rate calculations & floating coupon amounts for the rest of our coupons.
The final step to calculate a fair value for our complete swap is to present value each floating coupon amount and fixed coupon amount using the discount factor for the coupon date.
Present Value of Net Coupon is
(Floating Coupon Amount - Fixed Coupon Amount) x Discount Factor
Our net fair value of this swap is $ 0.00 as of November 10, 2011.
So far in this tutorial we have gone through basic swap terminology, fixed leg coupon calculations, calculating forward rates for floating leg coupon calculations and discounted our cashflows to value a swap.
For more information see our pricing plans.
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