Pricing Interest Rate Swaps

This chapter shows that cash flows in a swap are equivalent to a replication portfolio consisting of a position in a fixed rate bond and a floating rate note (FRN). It analyses how the mark-to-market value of a swap changes through time in response to changes in interest rates and the number of remaining payments in the swap. An FRN is a bond with variable rate coupons based on future LIBOR rates. The chapter examines how to value an FRN at any date, using two different methods: the ‘short method’ and the ‘forward rate method’. The value of the swap changes over time as interest rates change and as the number of cash flows remaining changes. The swap rate is determined by the term structure of spot rates, at inception of the swap. The swap delta is a useful concept when swap dealers try to hedge the whole of their swaps book.