Master in Finance

Lecture 8
Building Blocks
Interest Rate Swaps (IRS)
Gianluca Fusai

Dipartimento SEI
Università del Piemonte Orientale
[email protected]
Faculty of Finance
Cass Business School, London, UK
[email protected]

Collegio Carlo Alberto - Master in Finance - Academic Year, 2015-16

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Outline I

1 IRS
Payoff

2 Uses of IRS

3 Pricing

4 Market Quotations

5 Key properties
Key 1: Swap and forward rates
Key 2: Swaps and par bonds (bootstrapping)

6 Risk Measures

7 The credit crunch and the basis spread

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 Interest Rate Swaps (IRS)

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Payoff

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Basic Products: Interest Rate Swaps

IRS consists in an agreement between two counterparts to exchange a series

of cash flows on pre-agreed dates in the future.
The most commonly traded swap (plain vanilla interest swap)
requires one side to pay a fixed rate and the other to pay a floating rate.
Payer swap: pays fixed and receive floating,
Receiver swap: pays floating and receive fixed.
This is fixed versus floating swap with the floating payment based on either
three-month, or six-month or 1 year LIBOR rate.
There are no cash-flows at inception.
The fixed rate is called the swap rate, while the floating rate is typically a
Libor rate.
The net cash flow of a payer IRS at each payment date is:

Notional x [LIBOR - SWAP RATE] x tenor

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Plain Vanilla US Interest Swap

Floating payments tied to three months LIBOR.

Payments made at three months intervals.
Floating rate determined three months and two days before each payment
date.
Fixed-side day count is 30/360.
Floating-side day count is actual/360.
The payments are netted every 3 months with the net payment equal to the
swap’s notional amount times:
90 - 3m LIBOR days ] ×Notional,
[Fixed Rate 360 360
where days is the number of days between two successive payment dates.

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Example
$1 million, one-year swap done on Monday, April 23, 1990, with quarterly
payments based on 3M LIBOR

Interest rate setting dates:

Trade Date
4/23 7/23 10/23 1/23
& & & &
4/25 7/25 10/25 1/25 4/25
Settlement known unknown unknown unknown
date payment payment payment payment
cash flows dates

Payments Amount:
Notional x [Fixed Rate (90/360) - LIBOR (days/360)]

where days is the actual number of days in the payment period (i.e. respectively
91 days, 92 days, 92 days and 90 days).

Contract basic features

N : nominal
Business day convention
Dates:
t : settlement date (or effective date)
T0 , . . . , Tn−1 : reset dates
T1 , . . . , Tn : payment dates
Tn : maturity (or termination date)
It can be t < T0 forward starting swap or t = T0 spot starting
swap.
Fixed leg (sequence of floating payments):
K = S (t, T0 , Tn ) : swap rate (fixed rate)
frequency
day count αFI
Floating leg (sequence of fixed payments):
floating rate (e.g., Libor)
frequency
day count αFL
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Time profile and cash flows of a payer IRS

Payer IRS Cash Flows

t Trading date
T0  1st reset date 
T1 & N αFL Le (T0 , T1 ) − αFI
T0, T1 T0, T1 K
... & ...
Ti −1  
Ti & N αFL FI
Ti −1 Ti L (Ti −1 , Ti ) − αTi −1, Ti K
e
Ti +1 &
... & ...
Tn−1 &  ... 
Tn N αFL e FI
Tn−1 Tn L (Tn−1 , Tn ) − αTn−1 Tn K

Notice that in a spot starting swap (t = T0 ) the first payment is known at

inception, since the first floating rate resets at T0 , while all future cash flows
remains random.

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Time profile and cash flows of a receiver IRS

Receiver IRS Cash Flows

t Trading date
T0  1st reset date 
T1 & N αFI
T0, T1 K − αFL
T0, T1 L (T0 , T1 )
... & ...
Ti −1  
Ti & N αFI
Ti −1 Ti K − αFL
Ti −1, Ti L (Ti −1 , Ti )
Ti +1 &
... &  ... 
Tn N αFI
Tn − 1 Tn K − αFL
Tn−1 Tn L (Tn−1 , Tn )

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Example: Cash flows under a hypothetical four-year
vanilla swap
Fixed payments are based on a 4.6% semi-annual rate.
Floating payments are based on 6-month Libor.
The initial Libor rate is known to be 2.8% at the outset, so the swap’s first
payment is certain.
Subsequent Libor rates are not known at the outset. Note that the final Libor
rate at 4.0 years is not used to calculate any of the swap’s cash flows.
The last column indicates cash flows to the receive-fixed party.
Cash flows to the receive-floating party are the negatives of these.
All cash flows are in millions of dollars. Note also how all USD 100MM
principal payments net to zero.
Cash Flows
Time (yrs) 6M Libor Fixed Leg Float Leg Net
0 2.8 -100 -100 0
0.5 3.4 2.3 1.4 0.9
1 4.4 2.3 1.7 0.6
1.5 4.2 2.3 2.2 0.1
2 5 2.3 2.1 0.2
2.5 5.6 2.3 2.5 -0.2
3 5.2 2.3 2.8 -0.5
3.5 4.4 2.3 2.6 -0.3
4 3.8 102.3 102.2 0.1

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Replicating a swap payoff

A swap is a portfolio of forward rate agreements.

PAYER IRS = PORTFOLIO OF LONG FRA CONTRACTS

RECEIVER IRS = PORTFOLIO OF SHORT FRA CONTRACTS

In a plain vanilla IRS there is no exchange of principal. However, if we assume

that the nominal is both received and paid at the swap maturity, then a swap
can be replicated by a portfolio of a floating-rate and a fixed-rate bond.

PAYER IRS = FLOATING-RATE BOND - FIXED-RATE BOND

RECEIVER IRS = FIXED-RATE BOND - FLOATING-RATE BOND

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 Uses of IRS

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Uses of IRS

Optimize the financial condition of debt (when firms have objective and
conditions on fixed/floating rate debt)
Convert the financial conditions of assets and liabilities
For example, given that

PAYER IRS = FLOATING-RATE BOND - FIXED-RATE BOND

we can transform a FRN in a Fixed-rate bond by entering a receiver swap

(selling a payer swap):

FIXED-RATE BOND = FLOATING-RATE BOND - PAYER IRS

Hedging of fixed-income portfolios against any change in the yield curve by

exploiting the DV01 of the swap, similarly to what we did for the FRA.

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Pricing

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Valuation of a Payers IRS

Two problems:

1 At the inception date, find the fixed rate that equates the value of the
fixed and floating leg.

2 Away from the inception date, given the swap rate, find the current value
of the swap.

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Valuation of a Payers IRS: Fixed payment

PV of fixed payment
At time Ti , the fixed leg pays the amount:

αFI
Ti −1, Ti × K × N

The fixed payment occurring at time Ti has present value

P (t, Ti ) × αFI
Ti −1, Ti × K × N.

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Valuation of a Payers IRS: Floating payment

PV fixed payment
At time Ti , the floating leg pays the amount:

αFL
Ti −1, Ti × L (Ti −1 , Ti ) × N

where L (Ti −1 , Ti ) is fixed at time Ti −1 but the cashflow it determines is

paid at time Ti .
Using the recipe for the valuation of a floating amount, the floating payment
occurring at time Ti has present value

P (t, Ti ) × αFL
Ti −1, Ti × F (t, Ti −1 , Ti ) × N = (P (t, Ti −1 ) − P (t, Ti )) × N.

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Remark on pricing the floating leg

We can generate the amount αFL

Ti −1, T1 L (Ti −1 , Ti ) with the following strategy:

t Ti −1 Ti
−P (t, Ti −1 ) 1 −
− −1 FL
1 + αTi −1, Ti L (Ti −1 , Ti )
P (t, Ti ) − −1
P (t, Ti ) − P (t, Ti −1 ) − FL
αTi −1, Ti L (Ti −1 , Ti )

Therefore, by no-arbitrage,

P (t, Ti −1 ) − P (t, Ti )

is the time t value of the floating amount αFL

Ti −1, Ti L (Ti −1 , Ti ) received in Ti .

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Present Value of the floating and fixed leg

Present Value of the Fixed Leg

At the inception date, the present value of the fixed leg is
n
PVt (fixed leg) = ∑ P (t, Ti ) × αFITi −1, Ti × K × N. (1)
i =1

Present Value of the Floating Leg

At the inception date, the present value of the floating leg is
n
PVt (floating leg) = ∑ (P (t, Ti −1 ) − P (t, Ti )) × N. (2)
i =1

Notice that summing the differences we get

PVt (floating leg) = (P (t, T0 ) − P (t, Tn )) × N.

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Determination of the swap rate K

Equating the expressions in formulas 1 and 2 and solving respect to K , we

obtain the no-arbitrage swap rate at the inception of the contract: i.e. the
fixed rate K such that the swap value is zero.
Therefore we set K such that:

PVt (floating leg) = PVt (fixed leg)

This means to find K such that

n
∑ P (t, Ti ) × αFITi −1, Ti × K × N = (P (t, T0 ) − P (t, Tn )) × N
i =1

We get:
P (t, T0 ) − P (t, Tn )
K = ,
∑ni=1 P (t, Ti ) αFI
Ti −1, Ti

and K is called forward swap rate S (t, T0 , Tn ).

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Forward and par swap rates

The forward swap rate

If T0 > t, i.e. the first payment is forward in time, K is said forward swap rate
S (t, T0 , Tn ) and it is defined according to:

P (t, T0 ) − P (t, Tn )
S (t, T0 , Tn ) = n .
∑ P (t, Ti ) αFI
Ti −1, Ti
i =1

The spot swap rate

If T0 = t, i.e. the swap start date is spot, K is said par swap rate S (t, t, Tn ).

1 − P (t, Tn )
S (t, Tn ) ≡ S (t, t, Tn ) = n .
∑ P (t, Ti ) αFI
Ti −1, Ti
i =1

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The Annuity

The spot swap rate

In both formulae:
at the numerator we have the fair value of the floating leg, and
at the denominator, we have un annuity term:
n
A (t, T0 .Tn ) = ∑ αFI (Ti −1 , Ti ) × P (t, Ti ) .
i =1

that refers to the present value of a periodic strip of unit payments.

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Example (Problem: Computing the equilibrium swap rate)
Given the following strip of FRA rates
FRA(0, 0, 0.5)=4.95%
FRA(0, 0.5, 1)=5.00%
FRA(0, 1, 1.5)=5.10%
FRA(0, 1.5, 2)=5.20%
find the swap rate in a swap contract having
1 a notional principal of 1$,
2 a tenor of two years,
3 payments every six months,
4 spot starting.

Example (Solution: 2. Computing the PV of the two legs)

Given the strip of FRA rates we start computing the discount curve
P (0, 0.5), P (0, 1), P (0, 1.5), P (0, 2).

Start Ti End Ti +1 α i ,i + 1 F (t, Ti , Ti +1 ) P (t, Ti , Ti +1 ) P (t, Ti +1 )

0 0.5 0.5 4.95% 0.9758 0.9758
0.5 1 0.5 5.00% 0.9756 0.9520
1 1.5 0.5 5.10% 0.9751 0.9284
1.5 2 0.5 5.20% 0.9747 0.9048

Therefore, the present value of the floating leg is given by

PV (float.leg ) = 1 − P (0, 2) = 1 − 0.9048 = 0.0952.

The annuity term is

= α0,0.5 × P (0, 0.5) + α0.5,1 × P (0, 1) + α1,1.5 × P (0, 1.5) + α1.5,2 × P (0, 2)
= 1.8806.
Example (Solution: 2. Computing the Swap Rate)
The present value of the fixed leg is

PV (fixedleg ) = K × 1.8806.

Therefore, the fair swap rate is

0.0952
S (0, 0, 2) = = 0.050598265.
1.8806

Exercise

Problem
Given the following strip of FRA rates
FRA(0, 0, 0.5)=4.95%
FRA(0, 0.5, 1)=5.00%
FRA(0, 1, 1.5)=5.10%
FRA(0, 1.5, 2)=5.20%
find the swap rate in the previous swap contract such that the payer is gaining the
2% of the notional at the inception.

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Exercise

Problem
Given the following strip of FRA rates
FRA(0, 0, 0.5)=4.95%
FRA(0, 0.5, 1)=5.00%
FRA(0, 1, 1.5)=5.10%
FRA(0, 1.5, 2)=5.20%
find the swap rate in the previous swap contract such that the receiver is gaining
the 3% of the notional at the inception.

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IRS Quotations

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 Swap rates and market quotations
Actually the market quotes the spot starting swap rate S (t, t, Tn ) , for
different maturities Tn :
Euro GBP Sterling SwFr US Yen
Tenor Tn Bid Ask Bid Ask Bid Ask Bid Ask Bid Ask
1 yr 1.95 2 0.99 1.02 0.45 0.51 0.36 0.39 0.32 0.38
2 yr 2.34 2.39 1.62 1.66 0.86 0.94 0.76 0.79 0.34 0.4
3 yr 2.63 2.68 2.06 2.1 1.18 1.26 1.25 1.28 0.38 0.44
4 yr 2.85 2.9 2.43 2.48 1.45 1.53 1.72 1.75 0.46 0.52
5 yr 3.02 3.07 2.74 2.79 1.69 1.77 2.13 2.16 0.55 0.61
6 yr 3.16 3.21 2.98 3.03 1.89 1.97 2.48 2.51 0.67 0.73
7 yr 3.28 3.33 3.18 3.23 2.05 2.13 2.76 2.79 0.81 0.87
8 yr 3.38 3.43 3.35 3.4 2.17 2.25 2.99 3.02 0.95 1.01
9 yr 3.46 3.51 3.48 3.53 2.27 2.35 3.18 3.21 1.08 1.14
10 yr 3.54 3.59 3.59 3.64 2.36 2.44 3.34 3.37 1.21 1.27
12 yr 3.68 3.73 3.74 3.81 2.49 2.59 3.58 3.61 1.42 1.5
15 yr 3.84 3.89 3.88 3.97 2.61 2.71 3.82 3.85 1.67 1.75
20 yr 3.92 3.97 3.95 4.08 2.67 2.77 4.01 4.04 1.93 2.01
25 yr 3.87 3.92 3.96 4.09 2.67 2.77 4.1 4.13 2.03 2.11
30 yr 3.78 3.83 3.95 4.08 2.65 2.75 4.15 4.18 2.08 2.16

Table: Bid and ask rates as of close of London business (May 2nd, 2011). US $ is quoted
annual money actual/360 basis against 3 month Libor. £ and Yen quoted on a semi-annual
actual/365 basis against 6 month Libor. Euro/Swiss Franc quoted on annual bond 30/360 basis
against 6 month Euribor/Libor with exception of the 1 year rate which is quoted against 3
month Euribor/Libor. Source: ICAP plc. Historical quotes downloadable at
http://markets.ft.com/RESEARCH/Markets/DataArchive

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Swap rates and market quotations

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Swap rates and market conventions

Different payment frequencies, compounding frequencies and day count

conventions are applicable to each currency-specific interest rate type.
Currency EURO JPY USD GBP CHF
EURIBOR LIBOR or
Index LIBOR LIBOR LIBOR
or LIBOR TIBOR
FIXED LEG
A for 1yr
Payment freq. A S/A S/A A
then S/A
Day Count 30 ACT 30 ACT 30
Convention 360 365 360 365 360
FLOATING LEG
3m for 1yr 3m for 1yr
Payment freq. 6m 3m 6m
then 6m then 6m
Day Count ACT ACT ACT ACT ACT
Convention 360 360 360 365 360
Business Days Target Tokyo New York London Zurich
Roll Day modified following

Table: Quotation Basis for Interest Rate Swaps

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Euro Swap rates: market conventions

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USD Swap rates: market conventions

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GBP Swap rates: market conventions

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Yen Swap rates: market conventions

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Pricing away from inception

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How to value an IRS after initiation I

The value of a swap though customarily is set to zero at inception needs not
have zero value after inception.
A swap can be replicated by:
a portfolio of forward rate agreements;
a portfolio of floating-rate and fixed-rate bonds.
Of course, the two replicating strategies will provide the same price. The
second approach is straightforward.

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How to value an IRS after initiation II

Value of a Payer Swap away from inception

A swap contract having a fixed rate K and that has been set before the current
date t has value:

SWAPPAYER (t ) = FRN (t ) − CB (t )

1 + L (T0 , T1 ) αFL (T0 , T1 ) × P (t, T1 ) × N

=

− K × ∑ni=1 αFI (Ti −1 , Ti ) P (t, Ti ) + P (t, Tn ) × N

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Key properties

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Remarks I

Fact (Key 1: Swap rate and forward rates)

Swap rates are average of forward rates
n
∑ P (t, Ti ) αi −1 F (t, Ti −1 , Ti )
i =1
S (t, T0 , Tn ) = n . (3)
∑ P (t, Ti ) αi −1
i =1

Fact (Key 2: Swap rate as coupon of a par bond)

Swap rates are coupons not interest rates:
n
1= ∑ P (t, Ti ) S (t, t, Tn ) αFITi −1, Ti + P (t, Tn ) . (4)
i =1

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Remarks II

Fact (Key 3: Swap rate and term structure)

From swap rates with different maturity we can use a procedure (named
bootstrapping) to construct the discount curve. Indeed, recursively using the
following equation for n ≥ 2
n −1
1 − S (t, Tn ) ∑ P (t, Ti ) αTi −1 ,Ti
i =1
P (t, Tn ) = . (5)
1 + αTn−1 ,Tn S (t, Tn )

we can construct the discount curve. Some interpolation is needed if payments do

not have yearly frequency.

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 Key 1: Swap and forward rates

Fact (Swap rates as average of simple forward rates)

The forward swap rate S (t, T0 , Tn ) is a weigthed average of simple forward rates:
n
S (t, T0 , Tn ) = ∑ wi −1 F (t, Ti −1 , Ti ) ,
i =1

where the weights wi −1 are

P (t, Ti ) αi −1
wi − 1 = n .
∑ P (t, Ti ) αi −1
i =1

Indeed, exploiting the representation of floating payments in terms of simple

forward rates: .

PVFL (t ) ∑ni=1 F (t, Ti −1 , Ti ) × αFL (Ti −1 , Ti ) × P (0, Ti )

S (t, T0 , Tn ) = =
A (t, T0 , Tn ) ∑ni=1 αFI (Ti −1 , Ti ) P (t, Ti )

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Swap rate and forward rates

The relationship between swap rate and forward rates is particularly

important in the relative valuation of caps and swaptions.
Caps are option contracts written on forward rates.
Swaptions are option contracts written on the swap rates.
In pricing caps using the Black’s formula, we assume that F (t, Ti −1 , Ti ) is
lognormal.
In pricing swaptions with the Black’s formula, we assume that S (t, T0 , Tn ) is
lognormal.
But the average of lognormals is not lognormal: if F are lognormal, S cannot
be lognormal as well.
Therefore, there is an inconsistency in using the Black model for pricing caps
as well as swaptions.

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Example: Swap rate and forward rates

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Key 2: Swaps and par bonds

Fact (Key 2: Par swap rate as coupon of a par bond)

The swap rate is the coupon of a par bond :
n
1= ∑ P (t, Ti ) S (t, t, Tn ) αFITi −1, Ti + P (t, Tn ) . (6)
i =1

Let us rewrite the equation that sets the swap rate:

n
1= ∑ P (t, Ti ) × S (t, t, Tn ) × αFITi −1, Ti + P (t, Tn )
i =1

This means that we can interpret the swap rate S (t, t, Tn ) as the coupon
rate payable at times Ti giving a bond a market price of 1 at the inception
time t.
It is customary to say that swap rates are equivalent to par coupon rates or
par yields.

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Key 3: Swap rates and discount factors I
Fact (Key 3: Swap rate and term structure)
From swap rates with different maturity we can use a procedure (named
bootstrapping) to construct the discount curve. Indeed, recursively using the
following equation for n ≥ 2
n −1
1 − S (t, Tn ) ∑ P (t, Ti ) αTi −1 ,Ti
i =1
P (t, Tn ) = . (7)
1 + αTn−1 ,Tn S (t, Tn )

we can construct the discount curve. Some interpolation is needed if payments do

not have yearly frequency.

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Key 3: Swap rates and discount factors II

From the definition of par swap rate:

1 − P (t, Tn ) 1 − P (t, Tn )
S (t, Tn ) = =
A (t, Tn ) A (t, Tn−1 ) + αFI
Tn−1 ,Tn P (t, Tn ) .

Solving for P (t, Tn ):

1 − S (t, Tn ) A (t, Tn−1 )

P (t, Tn ) =
1 + αFI
Tn−1 ,Tn S (t, Tn ) .

For n = 1, we have:

1 − P (t, T1 )
S (t, T1 ) =
P (t, T1 ) αt ,T1
1
→ P (t, T1 ) = .
1 + αt ,T1 S (t, T1 )

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Key 3: Swap rates and discount factors III

For n = 2:
1 − P (t, T2 )
S (t, T2 ) = ,
P (t, T1 ) αt ,T1 + P (t, T2 ) αT1 ,T2
and then:
1 − S (t, T2 ) × A (t, T1 )
P (t, T2 ) = .
1 + αT1 ,T2 S (t, T2 )

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Remark 4: continued

For n ≥ 2:
1 − S (t, Tn ) × A (t, Tn−1 )
P (t, Tn ) = . (8)
1 + αTn−1 ,Tn S (t, Tn )
In the homework, using market quotations of swap rates and the recursion
(8), you will have to construct the discount function.
This relationship is important, because it allows to construct the discount
curve starting from (liquid) market quotations of swap rates.

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Example: Bootstrapping the swap curve

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Duration and DV01 of a swap

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Duration of a swap

Considering a fictitious payment of the notional at the expiry, a receiver swap

(receive fixed pays floating) can be tougth as sequence of
a long position in a coupon bond.
a short position a floating rate note.
The duration of the coupon bond can be computed according to the usual
procedure.
The duration of the FRN coincides with the time to next payment.
The duration (and the DV01) of a receiver swap is therefore equal to the
difference of the duration of the coupon bond and the time to next floating
payment.
Viceversa for a payer swap.

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DV01 of a swap I

Recalling the definition of swap rate and replacing it in the formula for
pricing a payer swap, we get that the PV of a payer swap can be written as

!
n
P (t, T1 ) × αFL
t0 ,T1 × (L (t0 , T1 ) − S (t0 )) + (S (t ) − S (t0 ))) × ∑ αFITi −1 ,Ti × P (t, Ti ) .
i =2

If we take as risk factor the swap rate itself, we immediately get the change
in the present value of the payer swap given a change in the swap rate: just
set equal to 1bp the change in the swap rate.
We so obtain the so called PVBP (present value of a basis point) of the payer
swap
∑ni=2 αFI
Ti −1 ,Ti × P (t, Ti )
PVBPswap = − .
10000
Notice that the payer swap (pay fixed) has a negative DV01, i.e. its market
value increases as interest rates move up.

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DV01 of a swap II

The above formula holds away from a reset date. At reset dates, the PVBP
becomes
∑ni=1 αFI
Ti −1 ,Ti × P (t, Ti )
PVBPswap = − ,
10000
i.e. the sum starts at i = 1 rather than at i = 2.
The PVBP of a receiver swap will be obtained by applying the above
formulas with a reversed sign.

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The credit crunch and the basis

spread

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The credit crunch and the appearance of the basis
spread I I

We have seen that in a perfect market, the value of the floating leg does not
depend on the frequency of the payments, but only on the discount factors
for the starting and ending date.
This means that if we have two swap contracts with the same fixed leg and
different frequency of payments in the floating leg (e.g. 3m or 6m), but with
the same swap tenor, the value of the swap should be the same.
After the credit crunch, this is anymore true. Market has started to quote
swap rates depending also on the frequency of payments of the floating leg.

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The credit crunch and the appearance of the basis

spread II

In reality, this occurred also before the crisis but the differences were
marginal.
Nowadays, we have a unique discount curve (built using the bootstrapping
procedure using quoations of OIS swaps) and different term structures for the
estimation of forward rates.
A real time interactive chart of the spread LIBOR 3m vs OIS can be found at
http://www.bloomberg.com/apps/quote?ticker=.LOIS3:IND

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Term Structure of Basis spread before and after the
crisis

Figure: Term structure of basis spreads (basis points) in the Euro market
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Overnight indexed swap (OIS) I

An overnight indexed swap (OIS) is an interest rate swap where the periodic
floating rate of the swap is equal to the geometric average of an overnight
index (i.e., a published interest rate) over every day of the payment period.
The index is typically an interest rate considered less risky than the
corresponding interbank rate (LIBOR).
In the United States, OIS rates are calculated by reference to daily federal
funds rate.
In the Euro market, OIS rates are calculated by reference to daily EONIA
(Euro OverNight Index Average) rate .

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Overnight indexed swap (OIS) II

The difference or spread between OIS rates and LIBOR are an important
measure of risk and liquidity in the money market, considered by many,
including former US Federal Reserve chairman Alan Greenspan, to be a
strong indicator for the relative stress in the money markets.
A higher spread is typically interpreted as indication of a decreased
willingness to lend by major banks, while a lower spread indicates higher
liquidity in the market.
As such, the spread can be viewed as indication of banks’ perception of the
creditworthiness of other financial institutions and the general availability of
funds for lending purposes.

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Time dynamics of the Basis spread (swap tenor 3yr)

Figure: Spread (basis points) vs OIS Swap (5 yr tenor) in the Euro market
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Historical Basis Spread

1m vs OIS 3m vs OIS 6m vs OIS 12m vs OIS

2004 n.a. 10.03 11.01 11.97
2005 n.a. 9.26 9.00 9.66
2006 n.a. 10.91 10.73 11.23
2007 12.89 18.51 19.04 19.70
2008 45.76 51.18 57.33 58.27
2009 19.60 38.52 50.03 51.16
2010 12.13 32.96 49.12 50.33
2011 15.86 31.37 44.37 45.37
avg 22.87 25.16 30.65 31.52
max 97.20 81.50 87.03 87.75
min -46.00 -22.50 -5.50 -4.60
std. dev. 19.35 17.20 21.45 21.63

Table: Yearly average and other quantities of Basis spread (in basis points) of 3 yr EUR
swap with different tenors of the floating leg vs the Eonia OIS

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Term Structure of Bootstrapped Spot and Forward

Rates with Basis spread

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 Conclusions

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Conclusions

The determination of the FRA and of the swap rate as well as their pricing
has requested no hypothesis about the future evolution of LIBOR rates.
The same holds true for FRN.
This depends on the fact that we have a linear payoff and we can use a static
hedging strategy.
The valuation of non-linear payoffs, like options on zcb, options on coupon
bond, cap, floor and swaptions, will require some hypothesis about the
interest rate dynamics.

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Main References I
1 Brigo Damiano and Fabio Mercurio, Interest Rate Models: Theory and
Practice, Springer Finance 2001.
2 Martellini Lionel, Priaulet Philippe and Priaulet Stèphane, Fixed Income
Securities, Wiley Finance, 2003. Chapters 10 and 11.

Additional useful references

Simple Interest Rate quotations

1 EURIBOR:
Euribor (official website of the European Banking Federation with a number of
institutional features and historical data as well) http://www.euribor.org
Il Sole 24 Ore (Italian Financial Newspaper) http://finanza-mercati.
ilsole24ore.com/reddito-fisso-e-tassi/tassi/euribor/euribor.php
2 LIBOR
British Banker Association http://www.bbalibor.com/ and for historical
quotations http://www.bbalibor.com/rates/historical
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Main References II

Financial Times http://markets.ft.com/RESEARCH/Markets/DataArchive

Il Sole 24 Ore (Italian Financial Newspaper) http://finanza-mercati.
ilsole24ore.com/reddito-fisso-e-tassi/tassi/libor/libor.php
3 Eurofutures quotations
Eurex http:
//www.eurexchange.com/market/quotes/INT/MON/FEU3_en.html#table
Financial Times http://markets.ft.com/RESEARCH/Markets/DataArchive
Chicago Mercantile Exchange and Nymex http:
//www.cmegroup.com/trading/interest-rates/stir/eurodollar.html
IRS conventions
1 http://www.isda.org/fix/isdafix.html
Papers on the basis spread after the credit crunch
1 M. Bianchetti, Two Curves, One Price: Pricing & Hedging Interest Rate
Derivatives Decoupling Forwarding and Discounting Yield Curves. Available
at SSRN:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1334356;

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Main References III
2 M. Bianchetti and M. Carlicchi, Interest Rates After the Credit Crunch:
Multiple Curve Vanilla Derivatives and SABR. Available at SSRN:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1783070;
3 M. Henrard, The Irony in the Derivatives Discounting Part II: The Crisis.
Available at SSRN:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1433022
4 M. Fujii, Shimada, Y. and Takahashi, A., A Note on Construction of Multiple
Swap Curves with and without Collateral (January 26, 2010). CARF Working
Paper Series No. CARF-F-154. Available at SSRN:
http://ssrn.com/abstract=1440633
5 M. Johannes and S. Sundaresan, Pricing Collateralized Swaps, Journal of
Finance 62 (2007).
6 V. Piterbarg, Funding beyond discounting: collateral agreements and
derivatives pricing, Risk, February 2010.
7 C. Whittall, The price is wrong, Risk magazine, Mar 2010, http:
//www.risk.net/risk-magazine/feature/1594823/the-price-wrong.

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