jarobi04

Schweser lists the two things that confuses people about swaps the most:
1) When valuing a swap, why do you include notional principal when no notional principal changes hands
2) How do you value a floating rate bond when future cash flows are unknown

I'll address both of these and hopefully it will clear this up.

1) Try to think of a swap in this manner. Person A issues a fixed rate paying bond with principal of $1,000,000 (the notional principal) at 5.0% (the swap rate). Person B buys this bond. With the $1,000,000, Person A buys a floating rate paying bond from Person B.

So the reason they say no notional principal is exchanged, is Person A would be getting $1,000,000 from Person B only to turn around and send it back to him when he buys the bond. And at the end of the swap, each person would send the other person $1,000,000. When you net these, $0 changes hands.

To value a swap though, you need to value a fixed rate bond and then value a floating rate bond. While at the end, the net notional principal that exchanges is $0, think to yourself that actually what is happening is each party pays each other the notional principal (which happens to be the par value of each bond).

That will allow you to value the bonds when you consider that each party will have to return the par value of the bond they issued to the other party at expiration.


2. Really the only thing that you need to remember about floating rate bonds is THEY RESET TO PAR AT EACH COUPON PAYMENT. The only time they deviate from par is inbetween coupon payments/reset dates. This was covered in Level 1 briefly.

So while I may not know what the cashflows are going to be past the next coupon date, I don't need to know them. We only have to worry about the cashflows that take place up until the reset date.

Look at the problem I did in my first post on how to handle floating rate bonds. You assume that at each payment, the entire bond is due (coupon payment + principal) then a new bond is issued at the new rate (which happens to be issued at par).


I forgot to mention that the method I use also works for any type of currency swap. To value the foreign bond, just multiply the notional amount by the beginning exchange rate then follow the same method. When you have the value of the foreign bond in foreign currency, multiply it by the current exchange rate to bring back to domestic currency.