Chapter 14 - Swap pricing. The main contents of the chapter consist of the following: Intuition into swap pricing, solving for the swap price, valuing an off-market swap, hedging the swap, pricing a currency swap. | © 2004 South-Western Publishing Chapter 14 Swap Pricing Outline Intuition into swap pricing Solving for the swap price Valuing an off-market swap Hedging the swap Pricing a currency swap Intuition Into Swap Pricing Swaps as a pair of bonds Swaps as a series of forward contracts Swaps as a pair of option contracts Swaps as A Pair of Bonds If you buy a bond, you receive interest If you issue a bond you pay interest In a plain vanilla swap, you do both You pay a fixed rate You receive a floating rate Or vice versa Swaps as A Pair of Bonds (cont’d) A bond with a fixed rate of 7% will sell at a premium if this is above the current market rate A bond with a fixed rate of 7% will sell at a discount if this is below the current market rate Swaps as A Pair of Bonds (cont’d) If a firm is involved in a swap and pays a fixed rate of 7% at a time when it would otherwise have to pay a higher rate, the swap is saving the firm money If because of the swap you are obliged to pay more than the current rate, the swap is beneficial to the other party Swaps as A Series of Forward Contracts A forward contract is an agreement to exchange assets at a particular date in the future, without marking-to-market An interest rate swap has known payment dates evenly spaced throughout the tenor of the swap Swaps as A Series of Forward Contracts (cont’d) A swap with a single payment date six months hence is no different than an ordinary six-month forward contract At that date, the party owing the greater amount remits a difference check Swaps as A Pair of Option Contracts Assume a firm buys a cap and writes a floor, both with a 5% striking price At the next payment date, the firm will Receive a check if the benchmark rate is above 5% Remit a check if the benchmark rate is below 5% Swaps as A Pair of Option Contracts (cont’d) The cash flows of the two options are identical to the cash flows associated with a 5% fixed rate swap If the floating rate is above | © 2004 South-Western Publishing Chapter 14 Swap Pricing Outline Intuition into swap pricing Solving for the swap price Valuing an off-market swap Hedging the swap Pricing a currency swap Intuition Into Swap Pricing Swaps as a pair of bonds Swaps as a series of forward contracts Swaps as a pair of option contracts Swaps as A Pair of Bonds If you buy a bond, you receive interest If you issue a bond you pay interest In a plain vanilla swap, you do both You pay a fixed rate You receive a floating rate Or vice versa Swaps as A Pair of Bonds (cont’d) A bond with a fixed rate of 7% will sell at a premium if this is above the current market rate A bond with a fixed rate of 7% will sell at a discount if this is below the current market rate Swaps as A Pair of Bonds (cont’d) If a firm is involved in a swap and pays a fixed rate of 7% at a time when it would otherwise have to pay a higher rate, the swap is saving the firm money If because of the swap you are obliged .
