Useful Concepts for Valuation of interest rate Swaps Fixed Coupon

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Useful Concepts for Valuation of interest rate Swaps Fixed Coupon Powered By Docstoc
					Useful Concepts for Valuation of (interest rate) Swaps

• (Fixed) Coupon bond: A bond that pays a pre-specified amounts at fixed interval of times, and principal at maturity.

• ”Par rate”: value coupon as fraction of principal so that Fixed coupon bond is worth par when issue.

• Floating rate bond: Bond that pays floating rate (variable) at intervals of time, and pays principal at maturity

• ”A floating rate bond is worth par” (after each payment date).

• dates 0 = t0, t1, ..., tj , ..., tn • Current date: t0, maturity tn. • Zero coupon rates between ti and tj : ri,j (current zero rates: r0,i) • Value at t = 0 of one dollar to be received at tj : e−r0,j ti • Value of ANY bond with payments Ci at ti at time t0 :
i=1 n X

e−r0,i ti Ci

• Coupon bond with Ci = C for i = 1, 2, ..., n − 1 and C + P at tn :
i=1 n X

e−r0,i ti C + e−r0,n tn P

• Coupon bond issue at par: coupon C must solve: P =
i=1 n X

e−r0,i ti C + e−r0,n tn P

• Example: What is the value of C/P (par rate) if the term structure is flat and ti are equally spaced? • In symbols: r0,i = r for all i, ti+1 − ti = ti − ti−1 = ∆ P = P 1 − e−rtn
³ ³ ´ ´
i=1 n X n X

e−r ti C + e−r tn P e−r ti C =⇒
³

= = =

1 − e−r∆ n

i=1 µ ¶X C n

1 − e−rtn
µ

¶ ´ C ³ −r∆ −r∆i = −r∆ i e e e P i=1 P i=0 µ ¶³ ´³ ´ C C e−r∆ 1 − e−r∆ n =⇒ = er∆ P P

´

=

i=1 ´ n−1 ³ X

n X

−r ti C e

P

- Par rate = constant interest rate per period

In general: a fixed coupon bond is issue at par if : P = or par rate
n X

e−r0,i ti C + e−r0,tn P
³ ´

i=1

C = Pn −r0,i ti P i=1 e

1 − e−r0,n tn

Now we consider a Floating Rate Bond.

• Floating rate bond: Bond that pays floating rate (variable) at intervals of time, and pays principal at maturity

• We use an arbitrage argument to show that ”A floating rate bond is worth par” (after each payment date).

• Cash flow of floating bond: t0 −P P ... ... P
h h

t1

t2

...

i h i r0,1 (t1−t0) − 1 P er1,2 (t2−t1) − 1 ... e

ti

...

tn

i h i ri−1,i (ti−ti−1) − 1 ... P ern−1,n (tn−tn−11) − 1 + P e

• Floating rate bond is worth P at t0, t1, ..., tn−1. • Suppose is worth more at t0. Short the bond, and invest in the short rate P at t0 . At t1 receive P er0,1(t1−t0) at t1. At t1 pay the floating rate from the short position and invest P. Keep doing this at every date, including maturity.

• Using the previous concepts (fixed coupon bond, floating bond) we can value a swap.

• Recall that a swap receiving variable rate and paying fixed rate has the same cash flows a long position in a floating bond and a short position in a coupon bond.

• We just showed that a floating bond is worth par at inception. • The fixed rate of the swap (the ”swap rate”) is determined so that the swap is worth zero at inception

• Then the swap rate is the par rate.

³ ´ • Determining the swap rate, i.e. the value of C at which a fixed for P

floating swap is issued.

• Recall that fixed coupon bond issue at par: P = or
i=1 n X

e−r0,i ti C + e−r0,tn P
³

C = Pn P e−r0,i ti i=1

1 − e−r0,n tn

´

• Floating (variable) rate bond issue at par: P. • Term structure of swap rate (paying every ti − ti−1 6 months) up to tn years, see WSJ, Mkt Data center, key interest rate, swap rates.

Swap cash flow (pay fixed, receives floating): t0 : P −P =0 P ti :
i ri−1,i (ti−ti−1) − 1 − C P e P h h

t1 :
i r0,1 (t1−t0) − 1 − C e P

... ...

...
h

tn :

i rn−1,n (tn−tn−1) − 1 − C + P − P ... P e P

Clearly it can also be valued as portfolio of FRA.


				
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