Fixed Income and Credit Risk

Prof. Michael Rockinger

B - 5 - Interest Rate Swaps

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Learning Objectives

Definition of an Interest Rate Swap (IRS)

Usefulness

Determining the Swap Rate, by discounting payoffs

Determining the Swap Rate, by decomposing payoffs

Bootstrap of discount curves from swap rates

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Interest Rate Swap (PV171)
A vanilla fixed-for-floating interest rate swap is a contract between two
counterparties in which:

One counterparty agrees to make n fixed payments per year at an

annualized swap rate c on a notional N up to a maturity date T , i.e., the
payment dates are T1 , T2 , . . . , Tm = T .
As usual, Ti = Ti−1 + ∆, ∆ = 1/n and assume i = 1, · · · , m

The other counterparty commits to make payments at the same dates linked
to a floating rate index rn (Ti−1 , Ti ),

The net payoff for the counterparty which pays fixed at date Ti is:
N · ∆ · (rn (Ti−1 , Ti ) − c) ,

What defines a counterparty is if it either pays fixed or receives fixed. Fixed

is the reference.
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Interest Rate Swaps, Payoffs

At time Ti payoff to fixed rate payer is therefore

N · ∆ · (rn (Ti−1 , Ti ) − c) ,

For i = 1, · · · , m.

T0 = 0 T1 T2 Tm
- Time

In real life the contract comes alive at T0 delivery date whereas price
was set at t = 0 value date. Typically between t = 0 and T0 there will
be 2 days. We will assume T0 = 0 to make our algebra a tiny bit
easier.

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Interest Rate Swap: example (PV174)
A firm and bank decide to enter into a fixed for floating semi-annual 5-year swap

5.4 INTEREST RATE SWAPS

with swap rate c = 5.46% and notional amount N = $200 mln. The reference
floating rate is the 6-month LIBOR.

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Interest Rate Swap: another example
A more realistic example. Today is April 28, 2020 and a firm sold a piece of
equipment to a highly rated corporation. The firm is due to receive payments in
10 equal semiannual installments of $5.5 mln each over next 5 years.
The firm would like to use these $5.5 mln semi-annual cash flows to hedge against
the coupon payments needed to service a $200 mln floating rate bond that it issued
in the past, which is expiring in 5 years.
Suppose that the floating rate on the corporate bond is tied to the LIBOR, at LIBOR +
4bps.
The 6-month LIBOR on March 1, 2001 is currently at 4.95% and so the next interest
rate payment the firm must make is:
(4.95 + 0.04)%
× $200 mln = $4.9 mln.
2

However, if the LIBOR were to increase by more than 0.51% in the next 5 years, the
cash flows from the installments would not be sufficient to service the debt.

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Interest Rate Swap: another example (continued)

A solution is to enter into a fixed for floating swap with an investment bank, in
which the firm pays the fixed semiannual swap rate c, over a notional of $200
million, and the bank pays the 6-month LIBOR to the firm.
On April 28, 2020, the swap rate for a 5-year fixed-for-floating swap is quoted at
c = 5.46%.
In this case, the net cash flow to the firm from the swap contract is:

$200 mln · 0.5 · (r2 (Ti−1 , Ti ) − 5.46%).

The firm’s net cash flow at Ti from the receivable, debt, and swap is:

$5.5 mln + $200 mln · 0.5 · (r2 (Ti − 0.5, Ti ) − 5.46%)

−$200 mln · 0.5 · (r2 (Ti − 0.5, Ti ) + 0.04%) = 0.

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Interest Rate Swap example: illustration (PV174)

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Determining the Swap Rate
There are two approaches to determine the swap rate.
In the first approach, one considers the individual payoffs and one
discounts those payoffs back to the initial date. This is something that
we have already done since each payoff can be viewed as a forward
rate agreement. Thus, it turns out that a swap is nothing but a
basket of FRAs.
In the second approach, one introduces a fictitious terminal payment
of the notional N from counterparty A to counterparty B and an
identical payment from counterparty B to counterparty A, and then
one recognizes that the fixed leg corresponds to a good’ol constant
coupon bond and the variable leg to a floating rate bond.
Once one has discounted the payoffs at the various dates, one sets
the initial value of the IRS to 0 and obtains the swap rate.
Both approaches yield the same expression for the swap rate: it is the
difference between the short discount factor and the long discount
factor, the whole divided by an annuity!
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Determining the Swap Rate: Discounting Payoffs

How can one compute the present value of the payoff at time Ti

∆ rn (Ti−1 , Ti ) N − ∆ c N

Easy part: Discount ∆ c N which yields ∆ c N Z(0, Ti )

To generate ∆ rn (Ti−1 , Ti ) N the insight is that this would be the
interest, and only that, if one had placed at time Ti−1 the amount N at
this rate rn (Ti−1 , Ti ). If one places at time Ti−1 an amount N one gets
at time Ti : (1 + ∆ rn (Ti−1 , Ti )) N. Thus by subtracting N at time Ti one
remains with the interest. The ‘discounted value’ of ∆ rn (Ti−1 , Ti ) N is
therefore

N · (Z(0, Ti−1 ) − Z(0, Ti )).

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Determining the Swap Rate: Discounting Payoffs
By considering all discounted payoffs and setting the swap rate so
that the swap has a zero value, we obtain the swap rate!

Value of swap is:

m
X m
X
V0 = ∆ c N Z(0, Ti ) − N · [Z(0, Ti−1 ) − Z(0, Ti )] = 0
i=1 i=1

Notice that
m
X
(Z(0, Ti−1 ) − Z(0, Ti )) = Z(0, T0 ) − Z(0, Tm ) = 1 − Z(0, Tm ).
i=1

Setting the initial value V0 of the swap equal to zero yields:

1 − Z(0, Tm )
c = Pm
i=1 ∆ Z(0, Ti )

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Interest Rate Swaps, Payoffs decomposed (approach 2)
Decompose the payments over the life of the swap into a floating and
a fixed payment. Also add a terminal payment of the notional amount
N (in red) which is just a trick so that both legs look like instruments
we know (FRN and bond)
recognize that with the trick A pays CF of a bond and receives CF of
an FRA

∆cN ∆cN ∆cN + N

Counterparty A ? ? ?

6 6 6
Counterparty B ∆rn (T0 , T1 )N ∆rn (Tm−1 , Tm )N + N
∆rn (T1 , T2 )N

T0 = 0 T1 T2 Tm
- Time

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Interest Rate Swaps, Payoffs decomposed
Value at t = 0 of bond
m
X
Z(0, Ti )∆ c N + Z(0, Tm ) · N
i=1

Value at t = 0 of floater
N
Both legs must have same value, swap has an initial value of 0:
m
X
N= Z(0, Ti )∆ c N + Z(0, Tm ) · N
i=1

Simplify and get:

1 − Z(0, Tm )
c = Pm
i=1 ∆ Z(0, Ti )

As promised, this is exactly what we were supposed to get before.

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Value of Interest Rate Swaps after t = 0

Suppose Tj−1 < t < Tj for some j

Value at t of bond
m
X
Z(t, Ti )∆ c N + Z(t, Tm ) · N
i=j

Value at t of floater
Z(t, Tj )N(1 + ∆rn (Tj−1 , Tj ))

Value of swap is:

m
X
V(c, t, Tj ) = Z(t, Tj )N(1 + ∆rn (Tj−1 , Tj )) − Z(t, Ti )∆ c N − Z(t, Tm ) · N
i=j

Formula does not look nice, c’est la vie.

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Bootstrapping the Swap Rate

In practice there is a large spectrum of swap rates cTi for many dates
Ti ∈ {0.5, 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 15, 20, 25, 30} years
Swaps are much many more liquid than bonds. So instead of using
bonds to bootstrap discount curves, use swap rates.

It is easy to estimate a curve running through all the dates (quarterly,

or semi annual) and estimate the parameters of such a curve via a
non-linear optimization program.

P. S. Hagan and G. West (2006). Interpolation Methods for Curve

Construction. Applied Mathematical Finance, Vol. 13, No. 2, 89-129,
June 2006

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Bootstrap swap rates
Once you know the discount curve, you can uniquely determine the swap rate for
every maturity Tm of a swap contract:
 
 1 − Z(0, Tm ) 
cn (0, Tm ) = n  Pm  ,
j=1 Z(0, Tj )

where we denoted cn (0, Tm ) the swap rate, calculated at inception, for the contract
maturing at Tm with ∆ = 1/n.
The swap curve is the set of swap rates for all maturities {cn (0, Tm )}m as a
function of Tm .
Swaps are very liquid instruments. Hence, market swap rates are often
used to back out (bootstrap) the discount curve:
1
Z(0, T1 ) = ,
1 + cn (0, T1 )/n
1 − (c(0, Tm )/n) · m−1
P
j=1 Z(0, Tj )
Z(0, Tm ) = .
1 + cn (0, Tm )/n
This later formula can be used recursively, m = 1, m = 2, and so forth...
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 Spot and swap curves: example
US spot and swap curves as of Mar 2020
Semi−annually compounded spot rate
Semi−annually compunded swap rate

2.5

2.0
Interest rate, %

1.5

1.0

0.5

1 2 3 4 5 6 7 8 9 10 12 14 16 18 20 22 24 26 28 30

Horizon, years

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