Interest rate swaps can be structured either over-the-counter with a specific dealer counterparty or exchange traded on one of the exchanges that clear interest rate swap transactions. A swap is an agreement to exchange payments based on a notional amount at specified future dates. Notional amount refers to the amount at which the settlement calculations are based. For example, one party may agree to pay a fixed rate of interest each month while the other party pays a floating or variable rate of interest. Settlements are calculated based on the difference between the fixed and variable rates based on the notional amount of the swap at the calculation date.
Accounting Treatment of Interest Rate Swaps
Interest rate swaps are considered derivatives under the accounting codification, such as ASC 820 and ASC 815, and must be recorded at fair value in financial statements. In addition, many derivatives, such as interest rate swaps qualify for hedge accounting treatment under specific accounting guidelines. HedgeStar provides fair value calculations of interest rate swaps for ASC 820 compliance and can help entities with their hedge accounting documentation under ASC 815.
Swap Pricing Methodology
How To Value An Interest Rate Swap
HedgeStar is an industry leader in swap valuations and can structure and value all types of derivatives and financial products. The value of a plain vanilla interest rate swap is derived by using the zero-coupon method. This method calculates the future net settlement payments required by the swap, assuming that the current forward rates implied by the yield curve correctly anticipate future spot interest rates. These payments are then discounted using the spot rates implied by the current yield curve for hypothetical zero-coupon bonds due on the date of each future net settlement on the swap.
Steps to Valuing an Interest Rate Swap
The mechanics behind valuing an interest rate swap include the following steps:
- Construct a zero coupon curve
- Project or forecast expected future rates (forwards)
- Determine discount factors for present valuing cash flows
- Discounting all the swap cash flows
Bootstrapping refers to the method by which one converts a known set of coupon rates (the spot yield curve) into a zero coupon curve. Because we need to know the rate at very specific cash flow dates in the future, we need to interpolate rates in between the standard curve data points. This is accomplished by formula and can be a piecewise constant, linear, quadratic or cubic. Once a zero coupon curve is established, the forwards curve is calculated for all the maturity dates. If the variable rate on the swap is 1-month LIBOR, the forward rates will be the 1-month LIBOR rate one day from now, 1-month LIBOR rate two days from now, and so on through the life of the swap. The forward rates are used to estimate the variable cash flows on the swap. Rates are converted into discount factors to present value all of the transaction cash flows to arrive at the valuation. The swap valuation is the total of all the cash flows, positive and negative.
Interest Rate Swaps
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