Notes for Lecture 4 (February 21)

Glenn Shafer

Valuation of a Forward Rate Agreement (pp. 95-96)

A forward-rate agreement (FRA) is a forward contract
where it is agreed that a certain interest rate RK will apply
to a certain principal to a specified future time period.
Example: You agree to borrow $100 from September 1,
2002 to December 31, 2002 at 6% interest.

The value of such a contract depends on the current

forward rate RF.
If the current September 90-day forward rate is 6%, then the
contract just mentioned has value zero. If that forward rate is
less than 6%, then the value of the FRA to the party receiving
the 6% is positive.

The value of the FRA to the party who is to receive RK is.

L(RK RF)(T2 T1)e-R2T2.
This is the present value of
L(RK RF)(T2 T1)
at time T2.
Why?
You can get an FRA with interest rate RF for free. If you
combine the paying side of this RF-FRA with the receiving
side of the RK-FRA, your only cash flow will be
L(RK RF)(T2 T1)
at time T2. So the value of the combination, which is also
the value of the RK-FRA, is the present value of this time
T2 payment.
Hull: An FRA can be valued by assuming that the
forward interest rate is certain to be realized.
1

Notes for Lecture 4 (February 21)

Glenn Shafer

Valuation of a Swap
A plain-vanilla swap can be thought of in two
different ways, which lead to two different ways
of valuing them:
You are swapping a bond with fixed-rate
payments for a bond with floating-rate
payments.
The fixed-rate bond can be valued as in the
preceding chapter, discounting each coupon
payment using the zero-coupon rate for its date.
The floating-rate bond has its face value as its
present value, immediately after the payment of
a coupon.

You are making a bundle of forward rate

agreements, together with some agreements

that have value zero to both parties.
Say the interest payments are at 6-month
intervals. Then on July 1, 2003, you receive a
payment at the fixed rate, say RK, and you pay
the floating rate in effect on January 1, 2003.
The agreement to accept the fixed rate RK is a
forward rate agreement, which can be valued as
on the preceding page. The agreement to pay
the floating rate has value zero.

Notes for Lecture 4 (February 21)

Glenn Shafer

Either way, it is customary to discount

using LIBOR.
The use of LIBOR rates hides an implicit
assumption: both parties have the creditworthiness of large banks.
If there is no risk of default, then the prices
have the solidity of arbitrage arguments.
But in practice, there may be substantial
risk of default, and therefore the prices are
less reliable than prices in an organized
futures market.
The risk is different for different parties.
If Company A swaps with Company B,
and Company A has a better credit rating,
then Company A has greater risk. If a
large bank plays the role of financial
intermediary, it is assuming most of the
risk.
This has implications for the proper
accounting of swaps.

Notes for Lecture 4 (February 21)

Glenn Shafer

Example 5.1
Bank has agreed to pay 6-month LIBOR and
receive 8% (semiannual) on $100 million.
Remaining life: 1.25 years.
LIBOR (continuous)
10% for 3 months
10.5% for 9 months
11% for 15 months.
The LIBOR 6-month rate at the last payment date
(3 months ago) was 10.2% (semiannual)
What is the value of the swap?

Fixed payments are $4m.

Floating payment due in 3 months is $5.1m.
Value of fixed bond is
Bfix = 4e-0.1x0.25 + 4e-0.105x0.25 + 104e-0.11x0.25 = $98.24 m

Value of floating bond is

Bfl = (100 + 5.1)e-0.1x0.25 = $102.51 m

Value of swap is
98.24 102.51 = $4.27 million

Notes for Lecture 4 (February 21)

Glenn Shafer

Problem 5.19
Under the terms of an interest rate swap, a financial
institution has agreed to pay 10% per annum and to
receive three-month LIBOR in return on a notional
principle of $100 million with payments being
exchanged every three months.
The swap has a remaining life of 14 months.
The average of the bid-ask fixed rate currently
being swapped for three-month LIBOR is 12% per
annum.
All rates are compounded quarterly.
The three-month LIBOR one month ago was
11.8% per annum (quarterly compounding).
What is the value of the swap?
Hint:
Convert the 12% to continuous compounding (this
gives 11.82%) and use it as the LIBOR of all
maturities to discount the future payments for both
the fixed and floating rate bonds.
But of course the 3-month LIBOR one month ago
defines the payment on the floating rate bond one
month from now.