Reading 25 Risk Management Example 8 - interest rate swap

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2. Consider a plain vanilla interest rate swap with two months to go before the next payment. Six months after that, the swap will have its final payment. The swap fixed rate is 7 percent, and the upcoming floating payment is 6.9 percent. All payments are based on 30 days in a month and 360 days in a year. Two-month Libor is 7.250 percent, and eight-month Libor is 7.375 percent. The present value factors for two and eight months can be calculated as follows:

11+0.0725(60/360)=0.988111+0.07375(240/360)=0.9531

The next floating payment will be 0.069(180/360) = 0.0345. The present value of the floating payments (plus hypothetical notional principal) is 1.0345(0.9881) = 1.0222. Given an annual rate of 7 percent, the fixed payments will be 0.07(180/360) = 0.035.

The present value of the fixed payments (plus hypothetical notional principal) is, therefore, 0.035(0.9881) + 1.035(0.9531) = 1.0210. Determine the amount at risk of a credit loss and state which party currently bears the risk. Assume a $1 notional principal.

Solution to 2:
The market value of the swap to the party paying fixed and receiving floating is 1.0222 – 1.0210 = 0.0012. This value is positive to the party paying fixed and receiving floating; thus this party currently assumes the credit risk. Of course, the value will change over the life of the swap and may turn negative, meaning that the credit risk is then assumed by the party paying floating and receiving fixed.

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