Page 134 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 9: Swaps

9.5 Mechanics of Swaps Notes

The price of the swap is the difference between the values of two cash flows. Swaps can be priced
by determining the values of each stream of cash flows. The value of each stream of cash flow is
nothing but the present value of cash flow in the stream. If the cash flow is in different currencies,
the present values are converted into a single currency at the prevailing exchange rate.
Swaps can be valued on the similar ways as bonds as they constitute a series of cash flows at
various points of time. The cash inflows are first discounted at an appropriate rate to find the
present value. This process is continued for cash outflows too. The difference between the
present value of inflows and outflows is simply the value of swap. Normally, the prevailing
LIBOR rate (in India, we use PLR rate) is used for discounting the cash flows of floating rate and
market quoted rate is used for fixed rate.

There are two approaches of swap valuation that are as follows:
1. Swap may be considered as long-term forward contract
2. Swap may be considered as portfolio of two bonds.

Swap Valuation Models

1. Valuation of Interest Rate Swaps: Let us assume that at maturity the fixed rate party and
the floating rate party provide each other equal amount of cash, then the value of swap is
nothing but the value of fixed coupon bond minus the floating rate note.
Symbolically,

P = V – V
i b f
Where P denotes the price or value of the swap; V denotes the value of fixed coupon
i b
bond; and V denotes the value of floating rate note.
f
At times when the market rate varies, the value of both the fixed and floating rate side will
be different. It is to be noted that the cash flows on the fixed leg do not change but discount
factor changes. On the floating side, both cash flows and discounting factor change.
2. Valuation of Currency Swap: In case of currency swaps, the valuation can be determined
by considering the swap as a portfolio of two bonds. So, the price of swap will be the
difference between the current value of both the bonds, one denominated in the foreign
currency and another in the local currency.

Symbolically,
P = V – V
c f l
Where P denotes the price or value of the currency swap; V denotes the value of foreign
c f
currency bond; and V denotes the value of local currency bond.
l

Example: Let us consider a flat rate of interest in India and the USA. The US rate is 3% per
annum and Indian rate is 8% per annum, both the rates being compounded continuously. The
ICICI Bank has entered into a currency swap where it receives 7.5 % per anum in Indian currency
and 4 % per annum in US dollars. The principal amount in both the currencies are ` 5 lakhs and
US $ 75 lakhs. The swap period is for two years and current exchange rate is 1 US$= ` 45.00.

The price of the currency swap is as given below:
P = V – V
c f l

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