Valuation of "Plain-Vanilla" Interest-Rate Swaps

16 Pages Posted: 21 Oct 2008

See all articles by Robert M. Conroy

Robert M. Conroy

University of Virginia - Darden School of Business

Kenneth M. Eades

University of Virginia - Darden School of Business

Abstract

This note takes students step by step through the valuation of an interest rate swap. It assumes students have a strong grounding in the concepts of forward rates and spot rates.

Excerpt

UVA-F-1121

VALUATION OF “PLAIN-VANILLA” INTEREST-RATE SWAPS

An interest-rate swap is a contract specifying the terms for exchanging fixed-rate interest payments for floating-rate interest payments. Such swaps have wide use in financial markets because they offer cost-effective ways to manage uncertainties about interest rates. This note introduces basic features of interest-rate swaps and focuses on how they can be valued. In particular, we examine what fixed-interest-rate payments will be traded for floating-rate payments in the market.

Structure of Interest-Rate Swaps

Debt contracts involve either fixed or floating interest rates. A floating-rate contract typically links the interest rate to a major market rate such as LIBOR. During the life of the floating-rate debt, the interest rate changes periodically to reflect changes in the market rate. In contrast, fixed-interest-rate contracts lock in a single interest rate for the duration of the loan. Fixed- and floating-rate contracts lead to very different interest-risk exposures for borrowers and lenders.

Consider a firm that has issued a three-year floating-rate debt instrument, where the floating rate is three-month LIBOR + 75 basis points (1 basis point equals 0.01%). While the firm knows the amount of its first interest payment (based on knowing the current level of LIBOR), the second and remaining interest payments will depend on future levels of LIBOR.

. . .

Keywords: interest rates, swaps

Suggested Citation

Conroy, Robert M. and Eades, Kenneth M., Valuation of "Plain-Vanilla" Interest-Rate Swaps. Darden Case No. UVA-F-1121, Available at SSRN: https://ssrn.com/abstract=1278882

Robert M. Conroy (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States

HOME PAGE: http://www.darden.virginia.edu/faculty/conroy.htm

Kenneth M. Eades

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4825 (Phone)
434-924-0714 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/eades.htm

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