MATH4511 Quantitative Methods for Fixed Income Securities

Lecture Note 2

Introduction to interest rate derivatives (Part 2)

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
Objective of Chapter 2
In earlier chapter, we study some basic types of interest rate derivatives (bond,
floating rate note and forward contract) and their application in portfolio
management and risk management. We also explore the pricing approach of
those derivatives using no arbitrage pricing principle.
In this Chapter, we shall study two popular types of interest rate derivatives
that are commonly traded in the financial market: Swap and options. We shall
study the following:
 Swap – Interest rate swap, commodity swap, equity swap and foreign
currency swap.
 Bond options, callable bond and puttable bond , interest rate cap, interest
rate floor (options on interest rate), swaptions (options on swap)

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
Swap
Swap is an agreement between two parties to exchange cash flows in future.
 The swap specifies the time (called payment dates) at which the payments
are made from both parties.
 The amount of cash flows involved in each payment is calculated based on
(i) predetermined interest rate or market interest rate in future
(interest rate swap),
(ii) interest rate/exchange rate of foreign currency (currency swap) or
(iii) future price of some assets (commodity swap or equity swap)
At time 0, two At each payment date,
Party Party
parties enter A B two parties exchange
into the swap the cashflows

0 𝑇1 𝑇2 ⋯⋯ 𝑇𝑛
Payment dates

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
In practice, the transaction of swap is done through a financial institution. The
financial institution serves as a middleman and process all payments involved in
the swap.
Apparently, the financial institution has entered into two swaps with two
parties respectively and the payments of two swap offset each other.

𝑿 𝑿
Party Middleman Party
(Clearing
A 𝒀 𝒀 B
house)

On this side, middleman On this side, middleman

enters into a swap (as enters into a swap (as
𝑋-receiver or 𝑌-payer) 𝑌-receiver or 𝑋-payer)
with Party A. with Party B.

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
Role of the financial institution in swap contract
This middleman plays an important role in the whole transaction:
1. Minimize the potential default risk faced by two parties
It is possible that one party may not fulfill the obligation if the loss is larger
than his/her expectation and another party will suffer. When one of the
parties default, the financial institution needs to fuifill the obligation with
another party. Hence, both parties will be free from the loss due to
potential default of another party.
(*Note: Since all default risk is shifted to the financial institution, so it will
demand a positive cost for compensation.)
2. Serve as a market makers
In general, it is not easy to have two parties entering into a same swap at
the same time. In this case, the financial institution will enter into a swap
without having an offsetting swap with another party.
(*Note: Without offsetting swap, the institution needs to offset its risk
using other instruments such as bonds, forward contract (or FRA) etc.)
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Lecture Note 2: Introduction to interest rate derivative (Part 2)
Interest rate swap
This is a swap which two parties exchange interest rate payments over a
specified period of time. An interest rate swap can be described as follows:
 The amount of interest rate payment is calculated based on some fixed
principal. It is known as principal (denoted it by 𝑁).
 One party is fixed rate payer (or floating rate receiver) who will pay fixed
interest rate for floating interest rate (calculated by some market
reference rate such as LIBOR). Another payer is floating rate payer (or fixed
rate receiver) who will pay floating interest rate for fixed interest rate.
 The actual amount of interest rate payment (fixed or floating) involved at
each payment date is defined as the total amount of interest earned by the
principal 𝑁 over the last payment period (calculated based on floating
rate/ fixed rate). That is,
𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 = 𝑁 × 𝑅[𝑇𝑗−1 ,𝑇𝑗 ] ,
where 𝑅[𝑇𝑗−1,𝑇𝑗 ] is the effective interest rate over the time interval [𝑇𝑗−1 , 𝑇𝑗 ].

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
Example 1 (An example of interest rate swap)
We consider a 3-year interest rate swap which 6-month LIBOR is exchanged for
a fixed interest rate at 3.8% every 6 months and the first exchange will be
made after 6 months. Both interest rates (6-month LIBOR and fixed rate) are
quoted as an annual nominal interest rate payable semi-annually.
Suppose that the notional principal is $100000, then
 The amount of each fixed payment (known as fixed leg) is
0.038
𝐹𝑖𝑥𝑒𝑑 𝑙𝑒𝑔 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 = $100000 × = $1900.
2
 The amount of 𝑖 𝑡ℎ floating payment (known as floating leg), payable at
𝑖
time 𝑇𝑖 = , is given by
2
𝐿[𝑇𝑖−1,𝑇𝑖 ]
𝐹𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑔 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 = $100000 × ,
2
𝑖−1 𝑖
Here 𝐿[𝑇𝑖−1,𝑇𝑖 ] = 𝐿[𝑖−1, 𝑖 ] is the 6-month LIBOR rate applied over [ , ],
2 2
2 2
quoted as annual nominal interest rate.
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Lecture Note 2: Introduction to interest rate derivative (Part 2)
Suppose the actual 6-months LIBOR rates at different times are given by
Now 0.5 1 year 1.5 2 years 2.5 3 years
years years years
6-months 3.2% 3.6% 4.1% 4.8%
4.2% 3.5%
3.6%
LIBOR
𝑳[𝑻𝒊−𝟏 ,𝑻𝒊]
Then the actual amount of 6 floating rate payments are determined to be
Payment 1st 2nd 3rd 4th 5th 6th
Floating $1600 $1800 $2050 $2400 $2100 $1750
rate leg
 The amount of 𝑘 𝑡ℎ floating rate payment is determined by the LIBOR rate
determined at previous payment date.
 In practice, the LIBOR rates in future are not known currently. So we only
know the amount of first floating rate payment and the amounts of other
payments are not known (and are random).
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Lecture Note 2: Introduction to interest rate derivative (Part 2)
Application of interest rate swap in risk management and portfolio
management
1. Use of swap in transforming a liability (e.g. loan)
We consider the following scenario: A company borrows an amount of 𝐿
from a bank and run its business. The loan charges interest at a floating
rate of {1 𝑦𝑒𝑎𝑟 𝐿𝐼𝐵𝑂𝑅 } + 1% (quoted as annual effective interest rate)
and the payment is made annually:
- The company only repays the interest charged at intermediate
repayment date and it repays the loan principal 𝐿 at last repayment
date.
Suppose that the company foresees that the interest rate is likely to grow
in future. This will increase the cost (interest payment) faced the company
and this will cause an inefficient outcome.
Question: Is it possible for the company to control the cost?

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
 To resolve this problem, the company can enter into a swap and exchange
fixed rate payment (with fixed annual interest rate 𝐾[𝑖−1,𝑖] = 𝐾) for
floating rate payment (calculated based on 1-year LIBOR) annually.
- By entering into swap, the floating rate payment received from the swap
can offset the interest payment of the loan so that the net payment paid
by the company at each payment date becomes fixed.
Before After
Company Company
Swap
𝑳 𝑹[𝒊−𝟏,𝒊] + 𝟎. 𝟎𝟏 𝑳 𝑹[𝒊−𝟏,𝒊] + 𝟎. 𝟎𝟏 𝑳𝑹[𝒊−𝟏,𝒊] 𝑳𝑲

Loan Financial
Loan
institution
Company suffers from Two floating payments
higher interest payment offset each other

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
2. Use of swap in managing the portfolio
On the other hand, interest rate swap is also useful in “transform” the assets in
the investment portfolio and allows investors to earn a higher return.
To see this, we consider the case when a fund manager is engaged in an
investment which earns floating interest rate (e.g. investing in floating rate
bond, lending the money at floating rate) periodically.
However, the manager forecasts from the market data that the market interest
rate is likely to go down in future. This decreases the manager’s future return
from the investment.
To avoid the low future return, the manager can enter into an interest rate
swap (with notional principal 𝑁) which he/she exchanges the floating rate
payment for fixed rate payment (with fixed rate 𝐾[𝑇𝑖−1,𝑇𝑖 ] , quoted as effective
interest rate) with a financial institution periodically.

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
 Before After
Manager Manager
Swap
𝑵𝑹[𝑻𝒊−𝟏,𝑻𝒊 ] 𝑵𝑹[𝑻𝒊−𝟏,𝑻𝒊 ]
𝑵𝑹[𝑻𝒊−𝟏,𝑻𝒊] 𝑵𝑲[𝑻𝒊−𝟏 ,𝑻𝒊]

Asset Financial
Asset
institution
Manager gets low return Two floating payments
from the investment offset each other

By investigating the new cashflow diagram of the fund manager, we observe

that the manager is “holding an asset which generates a fixed return”. In other
words, the swap transforms the assets earning floating rate return into the
assets earning fixed rate return.

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Valuation of interest rate swap
Next, we shall examine the pricing issue of the interest rate swap and we would
like to study the following issues:
1. Given that the swap is a mutual arrangement between two parties to
exchange payments (similar to forward contract or FRA), what should be
the fair value of fixed rate 𝐾 (called swap rate)?
2. Suppose that a swap is initialized at time 0, what will be the value of the
swap at future time 𝑡?
Model Setup
We consider the following interest rate swap with notional principal 𝑁:
 There are 𝑛 payment dates and are denoted by 𝑇, 2𝑇, …, 𝑛𝑇 (i.e. we also
assume implicitly that the payment periods are level).
 The amount of 𝑖 𝑡ℎ fixed payment is 𝑁𝐾[(𝑖−1)𝑇,𝑖𝑇] = 𝑁𝐾, where 𝐾 is the
effective fixed rate applied over the last payment period [(𝑖 − 1)𝑇, 𝑖𝑇].

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
  The amount of 𝑖 𝑡ℎ floating payment is 𝑁𝑅[(𝑖−1)𝑇,𝑖𝑇] , where 𝑅[(𝑖−1)𝑇,𝑖𝑇] is
the effective market interest rate (e.g. LIBOR) applied over [(𝑖 − 1)𝑇, 𝑖𝑇].
Determination of swap rate 𝐾
Similar to the case for forward contract/FRA, one need to determine the value
of swap at time 0. We consider the swap value at floating rate receiver side,
Note that the swap consists of both floating rate payments (cash inflows) and
fixed rate payments (cash outflows). Although the value of fixed rate payments
can be computed using present value approach, one has to determine the
value of floating rate payments using no arbitrage pricing principle.
Step 1: Value of fixed rate payment (fixed leg)
Using the standard discounting method, the present value of fixed rate
payment (denoted by 𝑉𝑓𝑖𝑥𝑒𝑑 ) is given by
𝑛 𝑛

𝑉𝑓𝑖𝑥𝑒𝑑 = ∑(𝑁𝐾 )𝐵(0; 𝑖𝑇) = 𝑁𝐾 ∑ 𝐵(0; 𝑖𝑇) … … (1).

𝑖=1 𝑖=1

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Step 2: Value of floating rate payments (floating leg)
To find the value of 𝑖 𝑡ℎ floating rate payment, one needs to construct a trading
strategy which can generate a payoff of 𝑁𝑅[(𝑖−1)𝑇,𝑖𝑇] at time 𝑇𝑖 .
We consider the following portfolio:
 Buy (𝑖 − 1)𝑇-years zero coupon bond with face value 𝑁;
 Short-sell 𝑖𝑇-years zero coupon bond with same face value 𝑁;
 At time (𝑖 − 1)𝑇, the amount 𝑁 received will be reinvested at interest rate
𝑅[(𝑖−1)𝑇,𝑖𝑇] .
So the portfolio will generate a payoff of 𝑁 1 + 𝑅[(𝑖−1)𝑇,𝑖𝑇] − 𝑁 =
𝑁𝑅[(𝑖−1)𝑇,𝑖𝑇] at time 𝑇𝑖 .
Using no arbitrage pricing principle, the current value of the 𝑖 𝑡ℎ floating rate
𝑖 ()
payment (denoted by 𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 ) equals the cost of constructing the portfolio:
()
𝑖
𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 = 𝑁𝐵(0; (𝑖 − 1)𝑇) − 𝑁𝐵(0; 𝑖𝑇).

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Hence, the total value of the floating leg is
𝑛

𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 = ∑ [⏟𝑁𝐵 (0; (𝑖 − 1)𝑇) − 𝑁𝐵(0: 𝑖𝑇)] = 𝑁 (𝐵

⏟(0; 0) − 𝐵(0: 𝑛𝑇)).
𝑖=1 (𝑖)
𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 =1

Step 3: Find the value of the swap and determine the swap rate
The value of the swap (floating rate receiver position) at initialization date is
𝑛

𝑉0 = 𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 − 𝑉𝑓𝑖𝑥𝑒𝑑 = 𝑁 1 − 𝐵(0; 𝑛𝑇) − 𝑁𝐾 ∑ 𝐵(0; 𝑖𝑇).

𝑖=1
To determine the swap rate, we note that swap is a mutual agreement
between two parties to exchange payments. Since there is no side-payment
involved, the swap value must be 0 at initialization date. So 𝐾 must satisfy
𝑛
1 − 𝐵(0; 𝑛𝑇)
𝑁 1 − 𝐵(0; 𝑛𝑇) − 𝑁𝐾 ∑ 𝐵(0; 𝑖𝑇) = 0 ⇒ 𝐾 = 𝑛 .
∑𝑖=1 𝐵(0; 𝑖𝑇)
⏟ 𝑖=1
𝑉0

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
Determine the value of on-going swap
We consider an interest rate swap which is initialized at time 0. To compute the
value of the swap at time 𝑡 (where 𝑡 > 0). One has to be careful that
 The swap value is calculated based on all unpaid payments made in future
time (i.e. 𝑇𝑖 > 𝑡).
 The amount of next floating payment is calculated based on the interest
rate quoted at previous payment date, which has been fixed already.
We let 𝑇𝑘 (where 𝑘 ≤ 𝑛) be the date of next payment. Then the value of the
interest rate at time 𝑡 can be computed as
𝑛 𝑛

𝑉𝑡 = 𝑁𝑅[(𝑘−1)𝑇,𝑘𝑇] 𝐵(𝑡; 𝑘𝑇) + ∑ [𝑁𝐵(𝑡; (𝑖 − 1)𝑇) − 𝑁𝐵 (𝑡; 𝑖𝑇)] − 𝑁𝐾 ∑ 𝐵(𝑡; 𝑖𝑇)

⏟ 𝑖=𝑘+1 ⏟ 𝑖=𝑘
𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑉𝑓𝑖𝑥𝑒𝑑

where 𝐵(𝑡; 𝑇) denotes the price of zero-coupon bond with face value 1 and
maturity date 𝑇. (*Note: The summation will be vanished if 𝑇𝑘 = 𝑇𝑛 .)

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
Example 2 (Pricing of interest rate swap)
We consider a 3-year interest rate swap initialized recently which the payments
are exchanged annually. You are given that
 The swap has notional principal 𝑁 = 100000;
 The interest rate of floating leg payment is calculated by 1-year LIBOR rate.
 The interest rate of fixed leg payment is 𝐾, which is quoted as annual
effective interest rate.
 The first exchange will be made 1 year after today.
The current term structure of interest rate is presented in the following table:
6 months 1 year 1.5 year 2 years 2.5 years 3 years
LIBOR rate 1.5% 1.6% 1.8% 1.8% 2% 2.1%
Suppose that the term structure of interest rate after 6 months is given by
6 months 1 year 1.5 year 2 years 2.5 years 3 years
LIBOR rate 1.4% 1.7% 1.9% 2% 2% 2.3%
(*All rates are quoted as annual nominal interest rate convertible continuously)
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Lecture Note 2: Introduction to interest rate derivative (Part 2)
Question: Find the value of the swap (as floating rate receiver) at that time (i.e.
after 6 months).
Solution
We first determine the swap rate 𝐾, which is determined at time 0. Note that
the time 0 price of a 𝑇-year zero coupon bond (with face value 1) is given by
𝐵(0; 𝑇) = 𝑒 −𝐿[0,𝑇]𝑇 .
Hence, the swap rate 𝐾 (as effective interest rate) is found to be
𝑇𝑖 =𝑖
1 − 𝐵(0; 3) 1 − 𝑒 −0.021(3)
𝐾 =
⏞ = −0.016(1)
( ) ( ) (
𝐵 0; 1 + 𝐵 0; 2 + 𝐵 0; 3
⏟ ) 𝑒 + 𝑒 −0.018(2) + 𝑒 −0.021(3)
1−𝐵(0;𝑇𝑛 )
∑𝑛
𝑖=1 𝐵 (0;𝑇𝑖 )
≈ 0.021144.
Next, we compute the swap value after 6 months (0.5 years). Note that the
amount of next floating rate payment (to be paid at time 1) is 𝑁𝑅[0,1] =
100000 𝑒 0.016(1) − 1 = 1612.869 (not 𝑁𝑅[0.5,1] ).

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Therefore, the present value of the fixed leg payment and floating leg payment
are found to be
3

𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 = 1612.869𝐵
⏟ (0.5; 1) + ∑ 100000 𝐵(0.5; 𝑖 − 1) − 𝐵(0.5; 𝑖 )
𝑃𝑉 𝑜𝑓 1𝑠𝑡 𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 ⏟
𝑖=2
𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑃𝑉 𝑜𝑓 2𝑛𝑑 & 3𝑟𝑑 𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
= 1612.869𝑒 −0.014(0.5) + 100000 𝑒 −0.014(0.5)
−𝑒 −0.019(1.5)

+ 100000 𝑒 −0.019(1.5) − 𝑒 −0.02(2.5) ≈ 5781.12.

3

𝑉𝑓𝑖𝑥𝑒𝑑 = 100000𝐾 ∑ 𝐵(0.5; 𝑖 )

𝑖=1
= 100000(0.021144) 𝑒 −0.014(0.5) + 𝑒 −0.019(1.5) + 𝑒 −0.02(2.5)
= 6165.921.
Hence, the value of the swap is seen to be
𝑉 = 𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 − 𝑉𝑓𝑖𝑥𝑒𝑑 = −384.801.

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
Example 3 (Determining spot rates from swap rates)
The following table shows the spot rates of different terms
6 months 1 year 1.5 years 2 years
Spot rate 3% 3.2% 𝑠0 (1.5) 𝑠0 (2)
You are given that
 1.5 years swap rate (where the payments are made semi-annually) is 3.3%
 2 years swap rate (where the payments are made semi-annually) is 3.5%.
(*All rates above are quoted as annual nominal interest rate compounded
semi-annually.)
Determine 1.5-year spot rate and 2-year spot rate.
😊Solution
Recall that the swap rate is the fixed interest rate such that value of floating leg
equals the value of fixed leg.

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Since the 1.5-year swap rate is 𝐾 = 3.3%, we have
=1−𝐵(0;1.5)
⏞3
0.033 𝑖−1 𝑖
𝑁 𝐵(0; 0.5) + 𝐵 (0,1) + 𝐵(0; 1.5) = 𝑁 ∑ [𝐵 (0; ) − 𝐵 (0; )]
⏟2 2 2
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑥𝑒𝑑 𝑙𝑒𝑔
⏟ 𝑖=1
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑔

1 1 1 1
⇒ 0.0165 + 2+ 3 =1−
0.03 0.032 𝑠 (1.5) 𝑠 (1.5) 3
(1 + 2 ) (1 + 0 0
[ 2 ) (1 + 2 ) ] (1 + 2 )

⇒ 𝑠0 (1.5) = 0.033028.
Similarly, one can consider the 2-year swap rate 𝐾 = 3.5% and obtain
=1−𝐵(0;2)
⏞4
0.035 𝑖−1 𝑖
𝑁 𝐵(0; 0.5) + 𝐵 (0,1) + 𝐵(0; 1.5) + 𝐵(0; 2) = 𝑁 ∑ [𝐵 (0; ) − 𝐵 (0; )]
⏟2 2 2
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑥𝑒𝑑 𝑙𝑒𝑔
⏟ 𝑖=1
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑔

⇒ ⋯ ⇒ 𝑠0 (2) = 0.035075.

22 MATH4511 Quantatitive Methods for Fixed Income Securities

Lecture Note 2: Introduction to interest rate derivative (Part 2)
Other equivalent pricing formula of interest rate swap
In this section, we explore other approaches in pricing interest rate swap.
Recall that one key step in pricing swap is to construct a portfolio that
replicates the floating leg payment 𝑁𝑅[(𝑖−1)𝑇,𝑖𝑇] so that one can valuate the
floating leg payments.
In fact, there are more than one possible portfolios that can replicate the same
floating payment. By considering different portfolios, one can obtain different
version of pricing formula.
1. Pricing formula of swap using floating rate bond and fixed rate bond
By adding a notional principal 𝑁 to the cash inflow and cash outcome at
the last payment date, the interest rate swap (floating rate receiver) can
be viewed as a portfolio consists of
 Buy one unit of floating rate note with face value 𝑁 and coupon rate
equals to the floating rate 𝑅[(𝑖−1)𝑇,𝑖𝑇] ;
 Short-sell one unit of fixed rate coupon bond with face value 𝑁 and
coupon rate 𝐾 (over a coupon period).
23 MATH4511 Quantatitive Methods for Fixed Income Securities
Lecture Note 2: Introduction to interest rate derivative (Part 2)
 By no arbitrage pricing principle (or law of one price), the price of the
interest rate swap (denoted by 𝑉𝑡 ) is given by
𝑇𝑖𝑚𝑒 𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑇𝑖𝑚𝑒 𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓
𝑉𝑡 = { }−{ }.
𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑟𝑎𝑡𝑒 𝑛𝑜𝑡𝑒 𝑓𝑖𝑥𝑒𝑑 𝑟𝑎𝑡𝑒 𝑏𝑜𝑛𝑑
This is another pricing formula for interest rate swap.

Remark: Another interpretation of swap rate 𝐾

Recall that the swap value is 0 at initialization date (i.e. 𝑉0 = 0) and the
price of the floating rate note at initialization date equals to face value 𝑁.
So it follows that
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑓𝑖𝑥𝑒𝑑 𝑟𝑎𝑡𝑒
{ } = 𝑁.
𝑏𝑜𝑛𝑑 𝑎𝑡 𝑡𝑖𝑚𝑒 0
Hence, this formula provides another financial interpretation for the swap
rate. In fact, swap rate is the coupon rate 𝐾 in the fixed rate bond such
that the bond is sold at par (i.e. the bond price equals its face value).

24 MATH4511 Quantatitive Methods for Fixed Income Securities

Lecture Note 2: Introduction to interest rate derivative (Part 2)
 2. Pricing formula of swap using forward rate
𝑓𝑜𝑟𝑤𝑎𝑟𝑑
Recall that the forward rate 𝐾[(𝑖−1)𝑇,𝑖𝑇] reflects the “investor expectation”
(in layman tone) to the future interest rate 𝑅[(𝑖−1)𝑇,𝑖𝑇] , so it is possible to
find the value of floating leg payment using forward rate.
To see this, we consider a on-going swap at time 𝑡 (which the next
payment will be made at 𝑘𝑇 (> 𝑇). We consider a floating rate payment
payable at 𝑖𝑇 (with amount 𝑁𝑅[(𝑖−1)𝑇,𝑖𝑇] ) where 𝑖 > 𝑘.
To replicate this payment, we consider the following portfolio (constructed
at time 𝑡):
 Enter into FRA over the period [(𝑖 − 1)𝑇, 𝑖𝑇] in long position with
𝑓𝑜𝑟𝑤𝑎𝑟𝑑
forward rate 𝐾[(𝑖−1)𝑇,𝑖𝑇] and notional principal 𝑁 (The investor will get
𝑓𝑜𝑟𝑤𝑎𝑟𝑑
𝑁𝑅[(𝑖−1)𝑇,𝑖𝑇] − 𝑁𝐾[(𝑖−1)𝑇,𝑖𝑇] at time 𝑖𝑇).
𝑓𝑜𝑟𝑤𝑎𝑟𝑑
 Buy zero coupon bond with face value 𝑁𝐾[(𝑖−1)𝑇,𝑖𝑇] and maturity date
𝑓𝑜𝑟𝑤𝑎𝑟𝑑
𝑖𝑇 (This will generate a cash inflow 𝑁𝐾[(𝑖−1)𝑇,𝑖𝑇] at time 𝑖𝑇.)

25 MATH4511 Quantatitive Methods for Fixed Income Securities

Lecture Note 2: Introduction to interest rate derivative (Part 2)
 So the net payment of the portfolio at time 𝑖𝑇 is
𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑓𝑜𝑟𝑤𝑎𝑟𝑑
(𝑁𝑅[(𝑖−1)𝑇,𝑖𝑇] − 𝑁𝐾[(𝑖−1)𝑇,𝑖𝑇] ) + 𝑁𝐾[(𝑖−1)𝑇,𝑖𝑇] = 𝑁𝑅[(𝑖−1)𝑇,𝑖𝑇] .
By no arbitrage pricing principle, the value of the floating leg payment equals to
the current value of the portfolio. Since the value of FRA is 0, we have
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖 𝑡ℎ 𝑓𝑜𝑟𝑤𝑎𝑟𝑑
{ } = 𝑁𝐾[(𝑖−1)𝑇,𝑖𝑇] 𝐵(𝑡; 𝑖𝑇),
𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑔 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
where 𝐵(𝑡; 𝑖𝑇) denotes the current price of zero coupon bond with face value
1 and maturity date 𝑡.
Hence, the current value of the swap at time 𝑡 can be expressed as
𝑛
𝑓𝑜𝑟𝑤𝑎𝑟𝑑
𝑉𝑡 = ⏟ [(𝑘−1)𝑇,𝑘𝑇] 𝐵(𝑡, 𝑘𝑇)
𝑁𝑅 ⏟ [(𝑖−1)𝑇,𝑖𝑇] 𝐵 (𝑡; 𝑖𝑇)
+ ∑ 𝑁𝐾
𝑘𝑡ℎ 𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 (𝑓𝑖𝑥𝑒𝑑 ) 𝑖=𝑘+1 𝑖𝑡ℎ 𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
(𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 )
𝑛

− ∑ 𝑁𝐾[(𝑖−1)𝑇,𝑖𝑇] 𝐵(𝑡; 𝑖𝑇).

𝑖=𝑘

26 MATH4511 Quantatitive Methods for Fixed Income Securities

Lecture Note 2: Introduction to interest rate derivative (Part 2)
 𝑓𝑜𝑟𝑤𝑎𝑟𝑑
Note that the payment 𝑁𝐾[(𝑖−1)𝑇,𝑖𝑇] can represent the market’s (or investors)
expectation on the amount of floating rate payment 𝑁𝑅[(𝑖−1),𝑖𝑇] . The above
formula suggests that one can compute the present value of floating leg
payment by finding the “expected value” of the 𝑁𝑅[(𝑖−1),𝑖𝑇] and discount it
back to time 𝑡. That is,
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖 𝑡ℎ 𝑓𝑜𝑟𝑤𝑎𝑟𝑑
{ } = 𝑁𝐾 ⏟(𝑡; 𝑖𝑇) .
⏟ [(𝑖−1)𝑇,𝑖𝑇] × 𝐵
𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑔 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔
expected value
𝑜𝑓 𝑁𝑅[(𝑖−1),𝑖𝑇] 𝑓𝑎𝑐𝑡𝑜𝑟

Remark:
𝑓𝑜𝑟𝑤𝑎𝑟𝑑
In the above formula, the forward rate 𝐾[(𝑖−1)𝑇,𝑖𝑇] should be calculated based
on the spot rate quoted at time 𝑡 since we assume that the investor enters into
FRA at time 𝑡. That is,
𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝐵(𝑡; (𝑖 − 1)𝑇) 1 + 𝑅[𝑡,𝑖𝑇]
𝐾[(𝑖−1)𝑇,𝑖𝑇] = −1= − 1.
𝐵(𝑡; 𝑖𝑇) 1 + 𝑅[𝑡,(𝑖−1)𝑇]

27 MATH4511 Quantatitive Methods for Fixed Income Securities

Lecture Note 2: Introduction to interest rate derivative (Part 2)
 3. Pricing formula of swap rate quoted at time 𝑡
Recall that the swap rate is the fixed rate applied to fixed rate payment such that
the value of interest rate swap is zero at the initialization date.
Since the swap value equal to difference of present value of floating leg payment
and present value of fixed leg payment, one can use the definition of swap rate
(denoted by 𝐾𝑠𝑤𝑎𝑝 ) and deduce that
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑥𝑒𝑑 𝑙𝑒𝑔
{𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑔 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠} = {𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑤𝑖𝑡ℎ 𝑐𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 𝐾𝑠𝑤𝑎𝑝 }.
𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡 𝑞𝑢𝑜𝑡𝑒𝑑 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡
We consider an interest rate swap with swap rate 𝐾 (quoted as effective interest
rate over payment period) initialized at time 0. Suppose that the swap rate of the
same swap initialized at time 𝑡 is 𝐾𝑡 , then the value of the on-going interest rate
swap at time 𝑡 (denoted by 𝑉𝑡 ) can be expressed as
𝑃𝑉 𝑜𝑓 𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑃𝑉 𝑜𝑓 𝑓𝑖𝑥𝑒𝑑 𝑙𝑒𝑔 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
𝑉𝑡 = { }−{ }
𝑙𝑒𝑔 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑤𝑖𝑡ℎ 𝑐𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 𝐾
𝑃𝑉 𝑜𝑓 𝑓𝑖𝑥𝑒𝑑 𝑙𝑒𝑔 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑃𝑉 𝑜𝑓 𝑓𝑖𝑥𝑒𝑑 𝑙𝑒𝑔 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
={ }−{ }
𝑤𝑖𝑡ℎ 𝑐𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 𝐾𝑡 𝑤𝑖𝑡ℎ 𝑐𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 𝐾
𝑃𝑉 𝑜𝑓 𝑓𝑖𝑥𝑒𝑑 𝑙𝑒𝑔 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
={ }.
𝑤𝑖𝑡ℎ 𝑐𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 𝐾𝑡 − 𝐾
28 MATH4511 Quantatitive Methods for Fixed Income Securities
Lecture Note 2: Introduction to interest rate derivative (Part 2)
Example 4 (Pricing of swap using forward rate)
We consider an on-going swap which the floating rate receiver is agreed to pay
fixed payment at a fixed rate of 8% (quoted as annual nominal interest rate
compounded semi-annually) and receive a floating payment at 6-month LIBOR
on a notional principal of 𝑁 = $100000 every 6 months. You are given that
 The swap has remaining life of 15 months.
 The current LIBOR rates for 3-month, 9-month and 15-month maturities,
which are quoted as annual effective interest rate, are 9%, 9.5% and 10%
respectively.
 The 6-month LIBOR rates at the previous payment date was 9.3%.
Calculate the value of this swap using forward rate approach.
😊Solution
We take 𝑡 = 0 be the current time. To calculate the present value of floating
rate payments, one needs to compute the forward rates applied over the
period [0.25, 0.75] (i.e. 𝐾[0.25,0.75] )and [0.75, 1.25] (i.e. 𝐾[0.75,1.25] ) .
29 MATH4511 Quantatitive Methods for Fixed Income Securities
Lecture Note 2: Introduction to interest rate derivative (Part 2)
The forward rates 𝐾[0.25,0.75] and 𝐾[0.75,1.25] are found to be
(1 + 0.095)0.75
𝐾[0.25,0.75] = − 1 ≈ 0.04762,
(1 + 0.09)0.25
(1 + 0.1)1.25
𝐾[0.75,1.25] = − 1 ≈ 0.052399.
(1 + 0.095)0.75
On the other hand, the amount of first floating rate payment and each fixed
payment are 𝑁𝑅[−0.25,0.25] = 100000(1.0930.5 − 1) = 4546.64 and 𝑁𝐾 =
0.08
100000 ( ) = 4000 respectively.
2
Hence, the current value of the swap can be computed as
4546.64 0.04762(100000) 0.052399(100000)
𝑉𝑡 = + +
(⏟1 + 0.09) 0.25 (1 + 0.095) 0.75 (1 + 0.1)1.25
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 (𝐹𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑔 𝑝𝑎𝑦𝑚𝑒𝑛𝑡)
4000 4000 4000
−( + + ) ≈ 2347.49.
⏟ (1 + 0.09) 0.25 (1 + 0.095) 0.75 (1 + 0.1)1.25

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 (𝐹𝑖𝑥𝑒𝑑 𝑙𝑒𝑔 𝑝𝑎𝑦𝑚𝑒𝑛𝑡)

30 MATH4511 Quantatitive Methods for Fixed Income Securities

Lecture Note 2: Introduction to interest rate derivative (Part 2)
Example 5 (Application of swap rate)
One year ago, an investor entered into a 4-year interest rate swap (with semi-
annually payments) with swap rate 6% (quoted as annual nominal interest rate
compounded semi-annually) as floating rate receiver.
The current swap rate of various maturities (with semi-annually payments) are
given as follows:
1 year 2 year 3 years 4 years
Swap rate 5.7% 5.9% 6.2% 6.5%

(a) What can you say about the profitability of the swap?
(b) Suppose that the interest drops and the current swap rates become
5.4% (1 year), 5.6% (2 years), 5.8% (3 years) and 6.1% (4 years)
respectively. What can you say about the profitability of the swap?
If the swap becomes unprofitable, is it possible for the investor to stop the
loss?
31 MATH4511 Quantatitive Methods for Fixed Income Securities
Lecture Note 2: Introduction to interest rate derivative (Part 2)
😊Solution
(a) Recall that the value of on-going swap can be expressed as
𝑃𝑉 𝑜𝑓 𝑓𝑖𝑥𝑒𝑑 𝑙𝑒𝑔 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
𝑉𝑡 = { },
𝑤𝑖𝑡ℎ 𝑐𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 𝐾𝑡 − 𝐾
0.06
Note that 𝐾 = = 0.03. Since the swap has remaining life 3 years, we
2
0.062
have 𝐾𝑡 = = 0.031. This implies that 𝑉𝑡 > 0 and the swap is
2
profitable.
0.058
(b) Since 𝐾𝑡 becomes = 0.029, so we have 𝑉𝑡 < 0 and the swap is not
2
profitable. To stop any future loss, the investor can enter into another 3-
year swap as fixed rate receiver. Then the floating payments of those
two swaps offset each other so that the net future payments become
deterministic. The present value of the future payments is
3
𝑃𝑉 𝑜𝑓 𝑓𝑖𝑥𝑒𝑑 𝑙𝑒𝑔 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
𝑉𝑡 = { } = ∑ 𝑁(𝐾𝑡 − 𝐾 )𝐵(0; 𝑖 ).
𝑤𝑖𝑡ℎ 𝑐𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 𝐾𝑡 − 𝐾
𝑖=1

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
Other variants of interest rate swap
Example 6 (Deferred interest rate swap and its valuation)
We consider the following scenario. A company has made a 10-years floating
rate loan. The loan charges interest at 1-year LIBOR rate (currently 1%) and the
repayments are made annually. We assume that the company pays interest-
due only in first 9 repayments and the loan principal, together with the
interest-due, will be repaid at last repayment date (10th repayment).
Suppose that the company expects that the interest rate stays low during first 4
years and starts to climb after 4 years. To hedge the potential risk, the
company may consider to enter into an interest rate swap and exchange the
fixed rate payment for floating rate payment.
However, it may be too early to do so since the company may need to pay
more during the first 4 years. To resolve this problem, the company can choose
to enter into deferred interest rate swap which the first exchange is made 5
years after today (i.e. the first exchange is deferred by 4 years) and the
exchanges are paid annually until year 10.
33 MATH4511 Quantatitive Methods for Fixed Income Securities
Lecture Note 2: Introduction to interest rate derivative (Part 2)
The term structure of interest rate at current time is given as follows:
1 year 2 3 4 5 6 7 ⋯ 10
years years years years years years years
LIBOR 1% 1.2% 1.2% 1.2% 1.4% 1.4% 1.65% … 1.65%
rate
(*All rates are quoted as annual effective interest rate.)
Question: Determine the swap rate 𝐾 (quoted as annual effective interest rate)
for the deferred swap.
Solution
We first need to determine the current value of the deferred swap. Note that
 The present value of the fixed rate payment is
10 10
1
⏟ × 𝐵(0; 𝑖 ) = 𝑁𝐾 ∑
𝑉𝑓𝑖𝑥𝑒𝑑 = ∑ 𝑁𝐾 𝑖
= 5.333941𝑁𝐾.
𝑖=5 𝑃𝑉 𝑜𝑓 𝑖 𝑡ℎ 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑖=5 1 + 𝐿[0,𝑖]

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
  The present value of the floating rate payment is
10

𝑁𝐵(0; 𝑖 − 1) − 𝑁𝐵(0; 𝑖 ) = 𝑁[𝐵(0; 4) − 𝐵(0; 10)]

𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 = ∑ ⏟
𝑖=5 𝑃𝑉 𝑜𝑓 𝑖 𝑡ℎ 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
= 0.10437𝑁.
Thus, the current value of the swap is
𝑉0 = 𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 − 𝑉𝑓𝑖𝑥𝑒𝑑 = 0.10437𝑁 − 5.333941𝑁𝐾.
0.10437
By setting 𝑉0 = 0, we get 𝐾 = ≈ 0.019567.
5.333941
Remark of Example 6
 Deferred swap is also known as forward swap in financial community. It is
because the deferred swap can be seen as a forward contract on swap
which the investor is obligated to enter into the underlying swap at a fixed
swap rate 𝐾 at future time.

35 MATH4511 Quantatitive Methods for Fixed Income Securities

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  Although the investor can choose entering into an ordinary interest rate
swap at time 4 (instead of entering into deferred swap), he/she may need
to pay higher fixed rate 𝐾 since the swap rate 𝐾 is calculated based on the
interest rate quoted at time 4.
For example, if the market interest rate at time 4 is given as follows:
1 year 2 3 4 5 6
years years years years years
LIBOR 2% 2% 2.3% 2.3% 2.3% 2.6%
rate
Then the swap rate applied to the 7-year interest rate swap at that time is
1 − 𝐵(4; 10)
𝐾= 6
∑𝑖=1 𝐵 (4; 4 + 𝑖 )
1 − (1.026)−6
= ≈ 0.025771.
(1.02)−1 + (1.02)−2 + (1.023)−3 + ⋯ + (1.026)−6
which is higher than the swap rate in the deferred swap (i.e. 0.019567).

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
  One may ask whether it is more profitable for investor to enter into the 10-
year swap now because of lower swap rate.
By direct computation, the swap rate of 10-year interest rate swap is
1 − 𝐵(0; 10) 0.150964
𝐾 ∗ = 10 = ≈ 0.016376,
∑𝑖=1 𝐵(0; 𝑖) 9.218719
which is lower than the swap rate (𝐾 = 0.019567) of the deferred swap.
This is expected since the swap reflects the “average value” of the 1-year
interest rate applied over the 10 years.

Although the investor can enjoy a lower swap rate by entering into the 10-
year swap now, he/she may need to make a larger payment in the first 4
payments (comparing with deferred swap). Suppose that the 1-year
interest rate in the first 4 years remains to be around 1%, the investor
needs to pay an additional (0.016376 − 0.01)𝑁 = 0.006376𝑁 in the first
4 payments and this may override the benefit of paying less in the last 6
payments.

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
Example 7 (Amortizing swap – A variation of interest rate swap)
Background information
A company has owed the bank $1500000 recently. The company will repay the
loan by 5 level repayments made at the end of each year for 5 years. The loan
charges compounded interest at an annual effective interest rate 4%.
The following table shows the amortization schedule of this loan:
Payment Repayment Interest-due PrincipalOutstanding
amount repaid Balance
1500000
1st 336940.67 60000 276940.67 1223059.3
2nd 336940.67 48922.37 288018.3 935041.03
3rd 336940.67 37401.64 299539.03 635502
4th 336940.67 25420.08 311520.59 323981.41
5th (Last) 336940.67 12959.26 323981.41 0
(*Note: The interest-due at 𝑘 𝑡ℎ payment date is calculated by 0.04 ×
(𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝑎𝑡 (𝑘 − 1)𝑡ℎ 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑑𝑎𝑡𝑒)).
38 MATH4511 Quantatitive Methods for Fixed Income Securities
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Suppose that the company believes that the market interest rate is likely to
drop in future and it wishes to “switch” the loan into the floating rate loan. This
can be done by entering into an interest rate swap as floating rate payer.
However, the standard interest rate swap may not be applicable in this case
since the payments (fixed/floating) in the swap is calculated based on a
common notional principal 𝑁. However, the interest payment at each payment
date is calculated based on the outstanding balance at the previous payment
date which is decreasing over time. It is because part of the intermediate
repayments is used to repay the loan principal (i.e. principal repaid) in the
amortized loan so that the outstanding balance decreases.
Instead, the company can choose to enter into amortized swap which the
notional principal at each payment date is decreasing. In our case, it depends
on the outstanding balance at the previous repayment date. Suppose that the
interest rate of floating rate payment is 1-year spot rate and the current spot
rates of various maturities is given as follows:

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
 1 year 2 years 3 years 4 years 5 years
Spot rate 4.1% 3.8% 3.7% 3.7% 3.5%
𝒔𝟎 (𝒊)
Calculate the swap rate 𝐾 (as annual effective interest rate) of this amortized
swap.
😊Solution
We let 𝑁𝑖 (𝑖 = 1,2, … ,5) be the notional principal applied in 𝑖 𝑡ℎ payment. Then
𝑁𝑖 = 𝑂𝐿𝐵𝑖−1 , where 𝑂𝐿𝐵𝑗 denotes the outstanding balance at 𝑗𝑡ℎ repayment
date. Given this, the present values of 𝑖 𝑡ℎ fixed leg payment and floating leg
payment are found to be
𝑖 𝑁𝑖 𝐾
𝑉𝑓𝑖𝑥𝑒𝑑 = 𝑖
𝑎𝑛𝑑
1 + 𝑠0 (𝑖 )

𝑖 1 1
𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 = 𝑁𝑖 𝐵(0; 𝑖 − 1) − 𝐵(0; 𝑖 ) = 𝑁𝑖 ( 𝑖−1
− 𝑖
).
1 + 𝑠0 (𝑖 − 1) 1 + 𝑠0 (𝑖 )

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We summarize the present values of these payments in the following table:
Present value of Present value of
fixed leg payment floating leg payment
1st payment 1440922.2𝐾 59077.81
2nd payment 1135148.8𝐾 39740.02
3rd payment 838483.27𝐾 29349.34
4th payment 549543.27𝐾 20333.1
5th payment 272783.65𝐾 7375.66
Total 4236881.2𝐾 155875.9
So the swap value is given by
𝑉0 = 155875.9 − 4236881.2𝐾.
By setting 𝑉0 = 0, we deduce that 𝐾 ≈ 0.03679.
Remark of Example 7
Using this swap, the net interest rate charged to the borrower becomes
𝑖𝑛𝑒𝑡 = 0.04 + ⏟𝑅[𝑖−1,𝑖] − 0.03679 = 𝑅[𝑖−1,𝑖] + 0.00321.
𝑎𝑚𝑜𝑟𝑡𝑖𝑧𝑒𝑑 𝑠𝑤𝑎𝑝
41 MATH4511 Quantatitive Methods for Fixed Income Securities
Lecture Note 2: Introduction to interest rate derivative (Part 2)
Example 8 (Accreting swap – A variation of interest rate swap)
Accreting swap is a kind of interest rate swap which the notional principal is
increasing over payment period. That is, 𝑁1 < 𝑁2 < ⋯ < 𝑁𝑛 , where 𝑁𝑖
denotes the notional principal applied in 𝑖 𝑡ℎ payment. This swap is useful for
the company who needs extra capital to expand its business in future.
We consider an accreting swap which the investor can exchange fixed rate
payment (at rate 𝐾[(𝑖−1)𝑇,𝑖𝑇] = 𝐾) for floating rate payment (at rate 𝑅[(𝑖−1)𝑇,𝑖𝑇] )
at time 𝑖𝑇, where 𝑖 = 1,2, … , 𝑛. Both rates are effective interest rate over a
payment period.
Calculate the swap rate 𝐾 for this accreting swap.
😊Solution
Recall that the present values of 𝑖 𝑡ℎ fixed payment and 𝑖 𝑡ℎ floating payment
are given by
𝑖 𝑖
𝑉𝑓𝑖𝑥𝑒𝑑 = 𝑁𝑖 𝐾𝐵(0; 𝑖𝑇), 𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 = 𝑁𝑖 [𝐵(0; (𝑖 − 1)𝑇) − 𝐵(0; 𝑖𝑇)].
Hence, the value of the swap can be expressed as
42 MATH4511 Quantatitive Methods for Fixed Income Securities
Lecture Note 2: Introduction to interest rate derivative (Part 2)
 𝑛 𝑛

𝑉0 = ∑ 𝑁𝑖 [𝐵(0; (𝑖 − 1)𝑇) − 𝐵(0; 𝑖𝑇)] − 𝐾 ∑ 𝑁𝑖 𝐵(0; 𝑖𝑇).

𝑖=1 𝑖=1
Since the swap value should be 0 at initialization date, so we deduce that
∑𝑛𝑖=1 𝑁𝑖 [𝐵(0; (𝑖 − 1)𝑇) − 𝐵(0; 𝑖𝑇)]
𝑉0 = 0 ⇒ 𝐾 =
∑𝑛𝑖=1 𝑁𝑖 𝐵(0; 𝑖𝑇)
𝑛
𝑁𝑖 𝐵(0; 𝑖𝑇) 𝐵(0; (𝑖 − 1)𝑇) − 𝐵(0; 𝑖𝑇)
= ∑( 𝑛 )( )
∑𝑖=1 𝑁𝑖 𝐵(0; 𝑖𝑇) 𝐵 (0; 𝑖𝑇)
𝑖=1
𝑛
𝑁𝑖 𝐵(0; 𝑖𝑇) 𝑓𝑜𝑟𝑤𝑎𝑟𝑑
= ∑( 𝑛 ) 𝐾
⏟[(𝑖−1)𝑇,𝑖𝑇] .
∑ 𝑁
⏟ 𝑖=1 𝑖 𝐵 ( 0; 𝑖𝑇 )
𝑖=1 𝑓𝑜𝑟𝑤𝑎𝑟𝑑 𝑟𝑎𝑡𝑒
𝑤𝑒𝑖𝑔ℎ𝑡
𝑓𝑜𝑟𝑤𝑎𝑟𝑑
Recall that 𝐾[(𝑖−1)𝑇,𝑖𝑇] represents the market expectation to the floating rate
𝑅[(𝑖−1)𝑇,𝑖𝑇] , one can observe that the swap rate is the weighted average (weighted
by the present value of the notional principal) of the expected future interest rate
𝑓𝑜𝑟𝑤𝑎𝑟𝑑
𝐾[(𝑖−1)𝑇,𝑖𝑇] .

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Commodity swap
We consider an airlines company that has to purchase oil regularly for running
its operations. However, the price of oil fluctuates over time and the company
suffers from risk due to the price fluctuations. It is important for the company
to “control” the cost to secure its profit.
To hedge the market risk, the company may wish to enter into a commodity
swap with a financial institution. Under the terms of the commodity swap,
 the airline company receives spot price for a certain units of oil at each
exchange date.
 At the same time, the company pays a fixed amount 𝐾 per unit.
Spot price 𝑵𝑺𝒕 Fixed payment
(Oil)
(𝑲 per unit)
Oil Airlines Financial
market company institution
Oil Spot price 𝑵𝑺𝒕

Commodity swap
44 MATH4511 Quantatitive Methods for Fixed Income Securities
Lecture Note 2: Introduction to interest rate derivative (Part 2)
Hence, the airline company can purchase the oil at a fixed and predetermined
price ($𝐾 per unit). This allows the company to have a better control to its
budget.
In this section, we would like to examine the following issues:
 How to determine the fair value of 𝐾 (swap rate for commodity swap)?
 How to price an on-going commodity swap?
We consider a commodity swap which the payments are made at times
𝑇, 2𝑇, … , 𝑛𝑇. To determine the swap rate, we first calculate the swap value (at
floating rate receiver side) at the initialization date (time 0). Note that
 The present value of all fixed leg payments is
𝑛 𝑛
𝑁𝐾
𝑉𝑓𝑖𝑥𝑒𝑑 = ∑ 𝑁𝐾𝐵(0; 𝑖𝑇) = ∑ 𝑖𝑇
.
𝑖=1 1 + 𝑠0 (𝑖𝑇)
𝑖=1
𝑡ℎ
 Next, we consider the 𝑖 floating payment (with amount 𝑁𝑆𝑖𝑇 ) paid at
time 𝑖𝑇. To find the “present value” of this payment. We consider the
following portfolio:
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Lecture Note 2: Introduction to interest rate derivative (Part 2)
  Enter into 𝑖𝑇-year forward contract on 𝑁 units of the asset with
forward price 𝑓[0,𝑖𝑇] per unit.
 Buying a 𝑖𝑇-year zero coupon bond with face value 𝑁𝑓[0,𝑖𝑇] .
Then the net payoff of this portfolio at time 𝑖𝑇 is 𝑁𝑓[0,𝑖𝑇] + 𝑁 𝑆𝑡 − 𝑓[0,𝑖𝑇] =
𝑁𝑆𝑖𝑇 , which is same as the amount of 𝑖 𝑡ℎ floating payment.
By no arbitrage pricing principle, the present value of 𝑖 𝑡ℎ floating payment
equal to the value of the replicating portfolio:
𝑖
𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 = ⏟
0 ⏟ [0,𝑖𝑇] 𝐵(0; 𝑖𝑇) = 𝑁𝑓[0,𝑖𝑇] 𝐵(0; 𝑖𝑇).
+ 𝑁𝑓
𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝐵𝑜𝑛𝑑
Hence, the value of the swap at time 0 is given by
𝑛 𝑛

𝑉0 = ∑ 𝑁𝑓[0,𝑖𝑇] 𝐵(0; 𝑖𝑇) − ∑ 𝑁𝐾𝐵(0; 𝑖𝑇).

⏟
𝑖=1 ⏟
𝑖=1
𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑉𝑓𝑖𝑥𝑒𝑑

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By setting 𝑉0 = 0, we deduce that the swap rate is given by
𝑛
∑𝑛𝑖=1 𝑁𝑓[0,𝑖𝑇] 𝐵(0; 𝑖𝑇) 𝐵(0; 𝑖𝑇)
𝐾= = ∑( 𝑛 ) 𝑓[0,𝑖𝑇] ,
∑𝑛𝑖=1 𝑁𝐵(0; 𝑖𝑇) ∑ (
⏟ 𝑖=1 𝐵 0; 𝑖𝑇 )
𝑖=1
𝑤𝑒𝑖𝑔ℎ𝑡

which is the weighted average of the forward prices of different maturities.

Computing the value of on-going swap at time 𝑡 (𝑡 > 0).
We let 𝑘𝑇 be the next payment (exchange) date (i.e. (𝑘 − 1)𝑇 ≤ 𝑡 < 𝑘𝑇), one
can use the above result and show that the current value of the swap is
𝑛 𝑛 𝑛

𝑉𝑡 = ∑ 𝑁𝑓[𝑡,𝑖𝑇] 𝐵(𝑡; 𝑖𝑇) − ∑ 𝑁𝐾𝐵(𝑡; 𝑖𝑇) = 𝑁 ∑(𝐾𝑡 − 𝐾 )𝐵(𝑡; 𝑖𝑇),

⏟
𝑖=𝑘 ⏟
𝑖=𝑘 𝑖=𝑘
𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 𝑉𝑓𝑖𝑥𝑒𝑑

where 𝐾𝑡 denotes the swap rate of the commodity swap quoted at time 𝑡.

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Equity swap
In an equity swap, one party agrees to pay the return on an asset (e.g. stock,
index) on a notional principal 𝑁 over a series of scheduled payment date, while
the other promises to pay a fixed interest or floating interest (based on market
interest rate) on the same notional principal 𝑁. The actual transaction in the
equity swap at a 𝑖 𝑡ℎ payment date can be summarized by the following figure:
Party A pays the return of
the asset on principal 𝑵.
𝑬𝒊𝑻 −𝑬(𝒊−𝟏)𝑻
That is, 𝑵 ( )
𝑬(𝒊−𝟏)𝑻

Party Party
A B
Party B pays the interest on
principal 𝑵. That is, 𝑵𝑲 (𝒇𝒊𝒙𝒆𝒅)
or 𝑵𝑹[(𝒊−𝟏)𝑻,𝒊𝑻] (floating)
(*Note: 𝐸𝑡 denotes the value/price of the asset at time 𝑡.)

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Why do we need equity swap?
 It allows the investor to earn from the return of a target asset/index
without holding the asset. This is useful when the investor has difficulty in
buying the asset physically (e.g. the asset is foreign stock/fund or equity
index, transaction cost and tax).
 Suppose that an individual predicts the performance of a stock is going
worse in future and he/she would like to earn profit from this, the investor
can use the equity swap to secure the profit without shortselling the stock
(which may not be allowed in some market).
 Suppose that an individual owns a large amount of a company stock. If the
individual knows that the stock performance is going to be bad in future,
equity swap allows the individual to hedge against the downside loss
without selling the stock to the market. This can protect him the benefit
from holding the stock such as dividend or voting right.

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Valuation of equity swap
Next, we shall derive the pricing formula of an equity swap using no arbitrage
pricing principle. Similar to the case for interest rate swap, we compute
1. The value of the swap at the initialization date. This allows us to determine
the swap rate of the swap if necessary.
2. The value of the on-going swap at future time 𝑡
To start with, we first consider the equity swap which the floating interest rate
𝐸𝑖𝑇 −𝐸(𝑖−1)𝑇
payment 𝑁𝑅[(𝑖−1)𝑇,𝑖𝑇] is exchanged for equity return 𝑁 ( ).
𝐸(𝑖−1)𝑇

1. Value of equity swap at initialization date (time 0)

We shall compute the present values of floating rate leg and equity leg
respectively. Using the result derived from interest rate swap, the present
value of floating leg is given by
𝑛

𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 = ∑[𝑁𝐵(0; (𝑖 − 1)𝑇) − 𝑁𝐵(0; 𝑖𝑇)] = 𝑁 − 𝑁𝐵(0; 𝑛𝑇).

𝑖=1

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Lecture Note 2: Introduction to interest rate derivative (Part 2)
 Next, we consider the 𝑖 𝑡ℎ equity leg payment. To find its value, we
consider the following portfolio:
 Buy a (𝑖 − 1)𝑇-year bond with face value 𝑁. At time (𝑖 − 1)𝑇, invest
the amount 𝑁 received into the equity and
 shortsell a 𝑇-year bond with face value 𝑁.
𝑁 𝐸𝑖𝑇 −𝐸(𝑖−1)𝑇
The portfolio will generate a cashflow 𝐸𝑖𝑇 − 𝑁 = 𝑁 ( ) at
𝐸(𝑖−1)𝑇 𝐸(𝑖−1)𝑇
time 𝑖𝑇 which matches the 𝑖 𝑡ℎ equity payment.
By no arbitrage pricing principle, the current value of 𝑖 𝑡ℎ equity leg
payment equals to the value of the portfolio. That is,
𝑖
𝑉𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑁𝐵[0,(𝑖−1)𝑇] − 𝑁𝐵[0,𝑖𝑇] .
Thus, the present value of the equity leg payments is
𝑛

𝑉𝑒𝑞𝑢𝑖𝑡𝑦 = ∑ ⏟𝑁𝐵(0; (𝑖 − 1)𝑇) − 𝑁𝐵(0; 𝑖𝑇) = 𝑁𝐵(0; 0) − 𝑁𝐵(0; 𝑛𝑇)

𝑖=1 𝑖
𝑉𝑒𝑞𝑢𝑖𝑡𝑦
= 𝑁 − 𝑁𝐵(0; 𝑛𝑇).

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 Therefore, the current value of the swap at time 0 is
𝑉0 = [⏟𝑁 − 𝑁𝐵(0; 𝑛𝑇)] − [⏟𝑁 − 𝑁𝐵(0; 𝑛𝑇)] = 0.
𝑉𝑒𝑞𝑢𝑖𝑡𝑦 𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔
It appears that no side payment is needed for two parties to enter into the
contract.

2. Value of on-going equity swap (at intermediate time 𝑡)

Suppose that 𝑇𝑘−1 ≤ 𝑡 < 𝑇𝑘 , one can compute the value of two payments
as follows:
 The present value of the floating leg payments is
𝑛

𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 = 𝑁𝑅[(𝑘−1)𝑇,𝑘𝑇] 𝐵(𝑡; 𝑘𝑇) + ∑ [𝑁𝐵(𝑡; (𝑖 − 1)𝑇) − 𝑁𝐵(𝑡; 𝑖𝑇)]

𝑖=𝑘+1
= 𝑁𝑅[(𝑘−1)𝑇,𝑘𝑇] 𝐵(𝑡; 𝑘𝑇) + 𝑁𝐵(𝑡, 𝑘𝑇) − 𝑁𝐵(𝑡, 𝑛𝑇).
 To get the present value of the equity leg payments, we note that
 For 𝑖 ≥ 𝑘 + 1, the present value of 𝑖 𝑡ℎ equity payment is
𝑖
𝑉𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑁𝐵[0,(𝑖−1)𝑇] − 𝑁𝐵[0,𝑖𝑇] .

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  To find the value of 𝑘 𝑡ℎ equity payment paid at time 𝑘𝑇, we consider
𝑁
the following portfolio: Buy units of the equity and shortsell a
𝐸(𝑘−1)𝑇
zero coupon bond maturing at time 𝑘𝑇 with face value 𝑁, then the
𝑁 𝐸𝑘𝑇 −𝐸(𝑘−1)𝑇
portfolio value at time 𝑘𝑇 is 𝐸𝑘𝑇 − 𝑁 = 𝑁 ( ), which
𝐸(𝑘−1)𝑇 𝐸(𝑘−1)𝑇
𝑡ℎ
is same as the amount of 𝑘 equity payment.
By no arbitrage pricing principle, the value of 𝑘 𝑡ℎ equity payment
equals to the value of the replicating portfolio. That is,
𝑘 𝑁
𝑉𝑒𝑞𝑢𝑖𝑡𝑦 = 𝐸 − 𝑁𝐵(𝑡; 𝑘𝑇).
𝐸(𝑘−1)𝑇 𝑡
Combining, the present value of the equity leg payment is
𝑛
𝑁
𝑉𝑒𝑞𝑢𝑖𝑡𝑦 = 𝐸𝑡 − 𝑁𝐵(𝑡; 𝑘𝑇) + ∑ ⏟𝑁𝐵[0,(𝑖−1)𝑇] − 𝑁𝐵[0,𝑖𝑇]
𝐸
⏟(𝑘−1)𝑇 𝑖=𝑘+1 𝑖
𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 , 𝑖≥𝑘+1
𝑘
𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔
𝑁
= 𝐸𝑡 − 𝑁𝐵(𝑡; 𝑛𝑇).
𝐸(𝑘−1)𝑇

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  Hence, the value of the on-going swap is found to be
𝑁
𝑉𝑡 = [ 𝐸𝑡 − 𝑁𝐵(𝑡; 𝑛𝑇)]
𝐸
⏟ (𝑘−1)𝑇
𝑉𝑒𝑞𝑢𝑖𝑡𝑦

⏟ [(𝑘−1)𝑇,𝑘𝑇] 𝐵(𝑡; 𝑘𝑇) + 𝑁𝐵(𝑡, 𝑘𝑇) − 𝑁𝐵 (𝑡, 𝑛𝑇)]

− [𝑁𝑅
𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔
𝑁
= 𝐸𝑡 − 𝑁 1 + 𝑅[(𝑘−1)𝑇,𝑘𝑇] 𝐵(𝑡; 𝐾𝑇).
𝐸(𝑘−1)𝑇
On the other hand, one can consider the equity swap which fixed rate payment
(with rate 𝐾) is exchanged for equity payment. Using similar method (left as
exercise), one can show that
 The swap rate 𝐾 at time 0 (such that the swap value is 0) is
1 − 𝐵(0; 𝑛𝑇)
𝐾= 𝑛 .
∑𝑖=1 𝐵(0; 𝑖𝑇)
 The swap value at time 𝑡 (where (𝑘 − 1)𝑇 ≤ 𝑡 < 𝑘𝑇) is
𝑛
𝑁
𝑉𝑡 = 𝐸𝑡 − 𝑁𝐵(𝑡; 𝑛𝑇) − ∑ 𝑁𝐾𝐵 (𝑡; 𝑘𝑇).
𝐸(𝑘−1)𝑇
𝑖=𝑘
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Foreign currency Swap
Current swap allows the holder to exchange interest payment in one currency for
interest payment in another currency for a period of time. The amount of each
payment depends on a fixed notional principal and a certain interest rate (either
fixed or floating). Party A pays interest payment on
currency A. That is, 𝑵𝑨 𝑹𝑨[(𝒊−𝟏)𝑻,𝒊𝑻 ]
(floating) or 𝑵𝑨 𝑲𝑨 (fixed).
Party Party
A B
Party B pays the interest payment on
currency B. That is, 𝑵𝑩 𝑹𝑩
[(𝒊−𝟏)𝑻,𝒊𝑻] (floating)
or 𝑵𝑩 𝑲𝑩 (fixed)
*Note: Usually, the notional principals 𝑁𝐴 and 𝑁𝐵 are determined such that they
have the same values at the initialization date. That is, 𝑁𝐵 = 𝑆𝐵 𝑁𝐴 , where 𝑆𝐵
denoted the price (in currency A) of one unit of currency B.
*Note 2: Different from interest rate swap, notional principals are also exchanged
at the initialization date and end date of the currency swap.
55 MATH4511 Quantatitive Methods for Fixed Income Securities
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Application of currency swap
To motivate the use of currency swap, we consider the following scenario:
There are two companies (Company A and Company B) in different countries:
 Company A, which is a US company, would like to launch its business in Japan.
To do so, it needs to raise capital in Japanese yen.
 Company B, which is a Japanese company, would like to expand its business in
US. It needs capital in US dollars.
Although both companies can borrow the required capital from their local bank, they
need to pay higher borrowing cost since the bank may charge a higher interest rate for
borrowing foreign currency. The table below shows borrowing rates of two companies:
Borrowing Cost
USD JPN
Company A (US) 4.5% 4.2%
Company B (Japan) 5.2% 3%
(*Note: The above rates are quoted as annual effective interest rate. The repayments
are made annually.)

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We observe that two companies need to pay a higher interest rate payment if they
borrow the foreign currency directly from its local financial institution (comparing
with another countries).
Question: Is it possible for them to reduce the cost by some strategies?
Note that both companies can enjoy a lower cost if they borrow their local
currency. In other words, they have comparative advantage in their local currency
market. So it is possible for two companies to reduce the cost if they “co-operate”
and borrow the capital for another company. To do so, they can enter into a foreign
currency swap:
Step 1: (At time 0) Company A borrows USD dollar at 4.5% and Company B borrows
JPN dollar at 3%. They enter into currency swap and exchange the notional
principals.
𝑁𝑈𝑆𝐷
Company A Company B
(US) (JPN)
𝑁𝑌𝐸𝑁
𝑁𝑈𝑆𝐷 𝑁𝑌𝐸𝑁

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Step 2: At 𝑖 𝑡ℎ repayment date (i.e. time 𝑇𝑖 ), two companies exchange the interest
rate payment through the swap. Company A pays the interest payment of company
B’s loan and company B pays the interest payment of company A’s loan.
0.045𝑁𝑈𝑆𝐷
Company A Company B
(US) (JPN)
0.03𝑁𝑌𝐸𝑁
0.045𝑁𝑈𝑆𝐷 0.03𝑁𝑌𝐸𝑁

Step 3: (At time 𝑇𝑛 ) At the last repayment date, two companies exchange the
notional principal again and each company use the principal received to repay its
outstanding loan completely.
𝑁𝑈𝑆𝐷
Company A Company B
(US) (JPN)
𝑁𝑌𝐸𝑁
𝑁𝑈𝑆𝐷 𝑁𝑌𝐸𝑁

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Using currency swap, we see that company A can now borrow Japanese Yen at 3%
(instead of 4.2%) and company B can now borrow USD dollar at 4.5% instead of
5.2%. This greatly reduces their borrowing cost.
In general, the two companies may not know each other. In this case, they can
enter currency swap through a financial institution (cleaning house). The institution
will handle all payments involved in the currency swap between two parties. It will
charge some cost to each of two parties (due to credit risk, service fee):
0.045𝑁𝑈𝑆𝐷
0.045𝑁𝑈𝑆𝐷 𝟎. 𝟎𝟒𝟖𝑵𝑼𝑺𝑫
Company A Financial Company B
(US) Institution (JPN)
0.03𝑁𝑌𝐸𝑁 0.03𝑁𝑌𝐸𝑁
0.045𝑁𝑈𝑆𝐷 𝟎. 𝟎𝟑𝟑𝑵𝒀𝑬𝑵 0.03𝑁𝑌𝐸𝑁

 Under the currency swap, the financial institution earns 0.003𝑁𝑌𝐸𝑁 (in JPN
currency) and 0.003𝑁𝑈𝑆𝐷 (in USD currency)
 Although there will be a transaction cost, two companies are still willing to
enter the swap and enjoy the lower borrowing cost.
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Valuation of currency swap
Next, we examine the pricing of the currency swap. One challenge in the valuation
process is that multiple currency is involved in the swap and one has to convert all
payments into same currency to complete the valuation process.
To start with, we consider the following currency swap which the payments in
currency 𝐴 is exchanged for payments in currency 𝐵.
(*To facilitate the analysis, We take currency 𝐴 be the domestic currency and 𝐵 be
the foreign currency. The value of the currency swap is calculated in currency A.)
- There are 𝑛 exchange dates in the swap. Namely, 𝑇1 , 𝑇2 , … , 𝑇𝑛 , where 𝑇𝑖 = 𝑖𝑇.
- The notional principals of two currencies are 𝑁𝐴 (currency A) and 𝑁𝐵
(currency B) respectively. 𝑁𝐴 , 𝑁𝐵 are chosen such that they have the same
value at time 0. That is, 𝑁𝐴 = 𝑆𝐵,0 𝑁𝐵 , where 𝑆𝐵,0 is the exchange rate at 𝑡 =
0 (i.e. 1 unit of currency B = $𝑆𝐵,0 (in currency)).
- The interest rate applied in both currencies are fixed. We assume that the
interest rates over each payment period are 𝐾𝐴 (currency A) and 𝐾𝐵 (currency
B) respectively. (i.e. The swap is a fixed-fixed swap).

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We consider the position which the investor receives payments in currency B
(foreign currency receiver). To find the value of the currency swap, we need to
construct a portfolio which generates the cashflows that are identical to that of the
currency swap. Since all payments are fixed, one can consider the following
portfolio (constructed at time 0):
 For each 𝑖 = 1,2, … , 𝑛, we buy 𝑇𝑖 -year foreign zero-coupon bond with face
value 𝐾𝐵 𝑁𝐵 (in currency B) so that we can receive 𝐾𝐵 𝑁𝐵 at time 𝑇𝑖 .
 For each 𝑖 = 1,2, … , 𝑛, we short-sell 𝑇𝑖 -year zero-coupon bond with face value
𝐾𝐴 𝑁𝐴 (in currency A) and repay 𝐾𝐴 𝑁𝐴 at time 𝑇𝑖 . This generates a negative
cashflow 𝑁𝐴 𝐾𝐴 at time 𝑇𝑖 .
 (For last payments). We buy 𝑇𝑛 -year foreign zero-coupon bond with face value
𝑁𝐵 (in currency B) and short-sell 𝑇𝑛 -year zero-coupon bond with face value 𝑁𝐴
(in currency A).
Since the future payoffs of the portfolio match that of the currency swap, it follows
from no arbitrage pricing principal that the value of the currency swap at time 0
equals the value of the portfolio.

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We let 𝑉0 be the price of currency swap, we have
𝑛 𝑛

𝑉0 = 𝑆⏟
𝐵,0 [∑ 𝐾𝐵 𝑁𝐵 𝐵𝐹 (0; 𝑇𝑖 ) + 𝑁𝐵 𝐵𝐹 (0; 𝑇𝑛 )] − [∑ 𝐾𝐴 𝑁𝐴 𝐵(0; 𝑇𝑖 ) + 𝑁𝐴 𝐵(0; 𝑇𝑛 )],
𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 ⏟𝑖=1 ⏟𝑖=1
𝑟𝑎𝑡𝑒 𝑣𝑎𝑙𝑢𝑒 (𝑖𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝐵) 𝑣𝑎𝑙𝑢𝑒 (𝑖𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦 𝐴)

where 𝐵𝐹 (0, 𝑇) denotes the current price of foreign zero coupon bond with face
value 1 (in currency B/ foreign currency).
Some remark about the pricing formula of currency swap
 Pricing of on-going currency swap at time 𝑡
We let 𝑇𝑘 be the next payment date of the currency swap (i.e. 𝑇𝑘−1 ≤ 𝑡 < 𝑇𝑘 ).
Using similar method, one can deduce that the price of the swap at time 𝑡 is
𝑛 𝑛

𝑉𝑡 = 𝑆𝐵,𝑡 [∑ 𝐾𝐵 𝑁𝐵 𝐵𝐹 (𝑡; 𝑇𝑖 ) + 𝑁𝐵 𝐵𝐹 (𝑡; 𝑇𝑛 )] − [∑ 𝐾𝐴 𝑁𝐴 𝐵(0; 𝑇𝑖 ) + 𝑁𝐴 𝐵(0; 𝑇𝑛 )].

𝑖=𝑘 𝑖=𝑘
 Another pricing formula using forward price
On the other hand, one can derive the same formula using forward price of the
foreign currency. This can be done by treating currency B as an asset and
modifying the replicating portfolio.
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 To start with, we let 𝑓[0,𝑇] be the 𝑇-year forward price for 1 unit of currency B.
Recall from Chapter 1 that the forward price can be expressed as
𝑆𝐵,0 𝐵𝐹 (0; 𝑇)
𝑓[0,𝑇] = .
𝐵 (0; 𝑇)
We consider the following modified portfolio:
 For each 𝑖 = 1,2, … , 𝑛, we enter into 𝑇𝑖 -year forward contract on 𝑁𝐵 𝐾𝐵 units
of currency B and buy 𝑇𝑖 -year zero coupon bond with face value 𝑁𝐵 𝐾𝐵 𝑓[0,𝑇] .
By doing so, we can get 𝑁𝐵 𝐾𝐵 unit of currency B at time 𝑇𝑖 .
 For each 𝑖 = 1,2, … , 𝑛, we short-sell 𝑇𝑖 -year zero-coupon bond with face
value 𝐾𝐴 𝑁𝐴 (in currency A) and repay 𝐾𝐴 𝑁𝐴 at time 𝑇𝑖 . This generates a
negative cashflow 𝑁𝐴 𝐾𝐴 at time 𝑇𝑖 .
 (For last payments). We enter into 𝑇𝑛 -year forward contract on 𝑁𝐵 units of
currency B and buy 𝑇𝑛 -year zero coupon bond with face value 𝑁𝐵 𝑓[0,𝑇] . and
short-sell 𝑇𝑛 -year zero-coupon bond with face value 𝑁𝐴 (in currency A).
One can check that this portfolio generates cashflows which are identical to the
currency swap.

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By no arbitrage pricing principle and recall the face that the contract value is 0 at
initialization date 0, the current price of the swap can be expressed as
𝑛

𝑉0 = ∑ (0 + 𝐾𝐵 𝑁𝐵 𝑓[0,𝑇𝑖 ] 𝐵(0; 𝑇𝑖 )) + (0 + 𝑁𝐵 𝑓[0,𝑇𝑛 ] 𝐵(0; 𝑇𝑛 ))

𝑖=1
𝑛

− [∑ 𝐾𝐴 𝑁𝐴 𝐵(0; 𝑇𝑖 ) + 𝑁𝐴 𝐵(0; 𝑇𝑛 )]
𝑖=𝑘
𝑆𝐵,0 𝐵𝐹 (0;𝑇)
Using the fact that 𝑓[0,𝑇] = , we can deduce that
𝐵(0;𝑇)

𝑛
𝑆𝐵,0 𝐵𝐹 (0; 𝑇𝑖 ) 𝑆𝐵,0 𝐵𝐹 (0; 𝑇𝑛 )
𝑉0 = ∑ 𝐾𝐵 𝑁𝐵 ( ) 𝐵 (0; 𝑇𝑖 ) + 0 + 𝑁𝐵 ( ) 𝐵 (0; 𝑇𝑛 )
⏟ 𝐵 (0; 𝑇𝑖 ) ⏟ 𝐵 (0; 𝑇𝑛 )
𝑖=1
𝑓[0,𝑇 ] 𝑓[0,𝑇𝑛 ]
( 𝑖 ) ( )
𝑛

− [∑ 𝐾𝐴 𝑁𝐴 𝐵(0; 𝑇𝑖 ) + 𝑁𝐴 𝐵(0; 𝑇𝑛 )]
𝑖=𝑘
𝑛 𝑛

= 𝑆𝐵,0 [∑ 𝐾𝐵 𝑁𝐵 𝐵𝐹 (0; 𝑇𝑖 ) + 𝑁𝐵 𝐵𝐹 (0; 𝑇𝑛 )] − [∑ 𝐾𝐴 𝑁𝐴 𝐵(0; 𝑇𝑖 ) + 𝑁𝐴 𝐵(0; 𝑇𝑛 )].

𝑖=1 𝑖=𝑘
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Example 9 (Designing a currency swap)
There are two companies based in US and HK respectively. Suppose that company
A (based in US) wishes to borrow Hong Kong dollar (of amount 𝑁𝐻𝐾𝐷 ) for 5 years
and company B (based in Hong Kong) wishes to borrow US dollars (of amount
𝑁𝑈𝑆𝐷 ) for 5 years.
The following table shows the borrowing rates quoted by their local bank.
USD HKD
Company A 3.0% 5.6%
Company B 4.6% 6.0%
(*Note 1: The borrowing rates are quoted as annual nominal interest rate
compounded semi-annually.)
(*Note 2: Two companies will make interest payment semi-annually.)
(*Note 3: Here, company A is assumed to have better credit rating so that it can
borrow the money at lower rate.)
The current exchange rate is 1𝑈𝑆𝐷 = 7.8𝐻𝐾𝐷. The notional principals are taken to
be 𝑁𝑈𝑆𝐷 = 𝑈𝑆𝐷$10000 and 𝑁𝐻𝐾𝐷 = $78000. So two principals have same values.
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Question: Is it possible for the financial institution to design a 5-year currency swap
(with semiannual payments) which all parties are equally better off? (That is, two
companies can pay less interest payment and the institution can earn some profit.)
😊Solution
The design of the currency swap consists of two key steps:
Step 1: Identify a comparative advantage
Suppose that two companies are willing to borrow the money for another company
and exchange the payments through the swap.
 Suppose that the company A borrows the USD dollar (with principal
USD10000) for company B. At each repayment date, the company B can save
0.046 0.03
up to $(7.8) × [10000 ( − )] = 78000(0.008) (in HKD currency)
2 2
 Suppose that the company B borrows the HKD dollar (with principal
HKD$78000). At each repayment date, the company A can save up to
0.056 0.06
$78000 × [ − ] = 78000(−0.002) (in HKD currency)
2 2
Then the total net profit is 78000(0.008 − 0.002) = 78000(0.006) > 0 and there
is an advantage if they cooperate.
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Step 2: Design a currency swap
The idea is to distribute this additional benefit (of amount 78000(0.006)) to three
parties (two companies and financial institution) evenly so that they are equally
better off. We start with the following currency swap:
0.03𝑁𝑈𝑆𝐷 0.03𝑁𝑈𝑆𝐷
Company A Financial Company B
(US) Institution (HKG)

0.06𝑁𝐻𝐾𝐷 0.06𝑁𝐻𝐾𝐷
0.03𝑁𝑈𝑆𝐷 0.06𝑁𝐻𝐾𝐷

It is clear that company A is not better off in this scenario since it has to pay more
and the financial institution earns nothing. Thus, one needs to modify the cashflow
as follows:
𝟎. 𝟎𝟒𝟐𝑵𝑼𝑺𝑫
0.03𝑁𝑈𝑆𝐷 0.03𝑁𝑈𝑆𝐷
Company A Financial Company B
(US) Institution (HKG)
0.06𝑁𝐻𝐾𝐷 0.06𝑁𝐻𝐾𝐷
0.03𝑁𝑈𝑆𝐷 𝟎. 𝟎𝟓𝟐𝑵𝑯𝑲𝑫 0.06𝑁𝐻𝐾𝐷

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Under this swap, we have
0.056 0.052
 The company A can save up to $ ( − ) 𝑁𝐻𝐾𝐷 = $(78000)(0.002).
2 2
0.046 0.042
 The company B can save 𝑈𝑆𝐷 ( − ) 𝑁𝑈𝑆𝐷 = 𝑈𝑆𝐷 (10000)(0.002).
2 2
Using the current exchange rate, the value is $(78000)(0.002).
 Using the current exchange rate, the net profit of the financial institution at
each repayment date can be estimated as
0.042 0.03 0.052 0.06
𝑃𝑟𝑜𝑓𝑖𝑡 = (( − ( )
) 𝑁𝑈𝑆𝐷 ) 7.8 − ( − ) 𝑁𝐻𝐾𝐷
2 2 2 2
= 78000(0.002).
So they are equally better off (based on the data available today).
Remark of Example 9
Although two companies are strictly better off by entering currency swap, the
financial institution is facing foreign currency risk since the actual profit depends on
the exchange rate at the payment date (Here, we estimate the profit using today’s
exchange rate). To resolve this problem, the institution can enter into forward
contract on USD currency so that it can convert USD into HKD at a fixed rate.
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Example 10 (Valuation of foreign currency swap)
We consider the currency swap developed in earlier example. Suppose that the
term structure of interest rate of two currencies are both flat. You are given that
 The annual effective interest rate of USD dollar is 2.5% and
 The annual effective interest rate of HKD dollar is 4%.
Calculate the value of two currency swap (in HKD currency).
😊Solution
We consider the currency swap between company A and financial institution. Using
1 1
the formula established earlier with 𝐵(0; 𝑇) = (1.04)𝑇 and 𝐵𝐹 (0; 𝑇) = (1.025)𝑇, the
value of the currency swap (on company A’s side) is
10 0.03 10 0.052
10000 ( ) 10000 78000 ( ) 78000
𝐴
𝑉0 = 7.8 (∑ 2 + ) − (∑ 2 + )
𝑖 (1.025)5 𝑖 (1.04)5
⏟𝑖=1 (1.025)2 ⏟𝑖=1 (1.04)2
𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑈𝑆𝐷 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑣𝑎𝑢𝑒 𝑜𝑓 𝐻𝐾𝐷 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
= 7.8(10240.95) − 82345.7 ≈ −2466.3.

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Similarly, the value of the currency swap between company B and the
institution can be computed as
10 0.06 10 0.042
78000 ( ) 78000 10000 ( ) 10000
𝐵
𝑉0 = (∑ 2 + ) − 7.8 (∑ 2 + )
𝑖 (1.04)5 𝑖 (1.025)5
⏟𝑖=1 (1.04)2 ⏟𝑖=1 (1.025)2
𝑣𝑎𝑢𝑒 𝑜𝑓 𝐻𝐾𝐷 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑈𝑆𝐷 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
= 85151.15 − 7.8(10801.91) = 896.252.
Remark of Example 10 (Calculating the value of the currency swap)
The above example demonstrates an easy approach in calculating the value of
fixed-fixed currency swap.
 For each currency leg (HKD or USD), we calculate the present value of all
unpaid cashflows using the interest rate of that currency.
 If the currency is foreign currency, convert the value into domestic
currency using the current foreign exchange rate.

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Example 11 (Fixed-to-floating currency swap and its valuation)
Suppose that company 𝐴 wishes to borrow US dollars (of amount 𝑁𝑈𝑆𝐷 ) and
company 𝐵 wishes to borrow HKD dollars for 5 years (of amount 𝑁𝐻𝐾𝐷 ). The
following table shows the borrowing rate offered to two companies:
HK dollars US dollars
Company A 3.0% LIBOR + 1%
Company B 4.5% LIBOR + 1.5%
(*Note: All rates are quoted as annual effective interest rate. In addition, we
assume that the company will make interest payment to the loan annually.)
You are given that
 The current exchange rate is 1𝑈𝑆𝐷 = $7.8 𝐻𝐾𝐷.
 The term structure of both currencies are flat. The annual effective interest
rates of HK dollar and US dollar are 2.5% and 3.5% respectively.
 The notional principals are chosen such that 𝑁𝐻𝐾𝐷 = 7.8𝑁𝑈𝑆𝐷 (two
principals have same values at initialization date).
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Lecture Note 2: Introduction to interest rate derivative (Part 2)
 (a) Is it possible to design a currency swap for company A and company B
such that the financial institution can earn a spread of 50 basis points (=
0.5%) and the swap is equally attractive to both companies?
(b) Hence, determine the price of the currency swap (at company A’s side)
between company A and the financial institution.
😊Solution
(a) To design a suitable swap, we first calculate the additional benefit
earned at each repayment date if two companies enter into the currency
swap and borrow the capital for another company.
 If company A borrows HK dollars for company B, then company B
can save an amount $𝑁𝐻𝐾𝐷 (0.045 − 0.03) = 0.015𝑁𝐻𝐾𝐷 .
 If company B borrows US dollars for company A, then company A
will “lose” an amount $7.8 𝑁⏟𝑈𝑆𝐷 𝐿 + 0.015 − (𝐿 + 0.01) =
𝑖𝑛 𝑈𝑆𝐷 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
𝑁𝐻𝐾𝐷 (0.005).
So the net profit is 0.015𝑁𝐻𝐾𝐷 − 𝑁𝐻𝐾𝐷 (0.005) = 0.01𝑁𝐻𝐾𝐷 .
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 Since the financial institution (FI) needs to earn a profit of 0.005𝑁𝐻𝐾𝐷 =
0.005(7.8)𝑁𝑈𝑆𝐷 from the swap, so each company should earn
1
(⏟
0.01𝑁𝐻𝐾𝐷 − ⏟
0.005𝑁𝐻𝐾𝐷 ) = 0.0025𝑁𝐻𝐾𝐷 (i.e. 0.25% of 𝑁𝐻𝐾𝐷 .
2
𝑇𝑜𝑡𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 (𝐹.𝐼.)
Given this fact, one can construct the currency swap as follows:

𝟎. 𝟎𝟒𝟐𝟓𝑵𝑯𝑲𝑫
0.03𝑁𝐻𝐾𝐷 0.03𝑁𝐻𝐾𝐷
Company A Financial Company B
(US dollar) Institution (HK dollar)
(𝐿 + 0.015)𝑁𝑈𝑆𝐷 (𝐿 + 0.015)𝑁𝑈𝑆𝐷
0.03𝑁𝐻𝐾𝐷 (𝐿 + 0.0075)𝑁𝑈𝑆𝐷
(𝐿 + 0.015)𝑁𝑈𝑆𝐷
As a verification, one can check that the profit made by financial
institution at each payment date is
𝑃𝑟𝑜𝑓𝑖𝑡 = (0.0425 − 0.03)𝑁𝐻𝐾𝐷 − 7.8(𝐿 + 0.015 − 𝐿 − 0.0075)𝑁𝑈𝑆𝐷
= 0.005𝑁𝐻𝐾𝐷 .

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 (b) To calculate the value of the currency swap, we calculate the present value of
the cash inflows (in HKD currency) and the cash outflows (in USD currency).
 Since spot rates of HKD currency is 𝐿[0,𝑇] = 2.5% for all 𝑇, hence the
present value of cash inflows is
5
0.03𝑁𝐻𝐾𝐷 𝑁𝐻𝐾𝐷
𝑉𝐻𝐾𝐷 = ∑ + = 1.023229𝑁𝐻𝐾𝐷 .
(1.025)𝑖 (1.025)𝑖
𝑖=1
 Using similar pricing approach as in valuating floating leg in interest rate
swap, the present value of the cash outflows (in HKD currency) is
5 5
1 1 0.0075𝑁𝑈𝑆𝐷
𝑉𝑈𝑆𝐷 = 7.8 (∑ 𝑁𝑈𝑆𝐷 ( − ) + ∑
(1.035)𝑖−1 ⏟
⏟ (1.035)𝑖 (1.035)𝑖
𝑖=1 𝑖=1
𝐵(0;𝑖−1) 𝐵 (0;𝑖 )

𝑁𝑈𝑆𝐷
+ ) = 1.033863𝑁𝐻𝐾𝐷 .
(1.035)𝑖

Thus, the current price of the currency swap (in HKD currency) is
𝑉0 = 1.023229𝑁
⏟ 𝐻𝐾𝐷 − 1.033863𝑁
⏟ 𝐻𝐾𝐷 = −0.01063𝑁𝐻𝐾𝐷 .
𝑉𝐻𝐾𝐷 𝑉𝑈𝑆𝐷
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Lecture Note 2: Introduction to interest rate derivative (Part 2)