An interest rate swap is a method by which two parties can exchange the interest payments on loans of equal principal value. According to Pimco.com, the most common interest rate swaps are performed between a party with a fixed-rate interest obligation and one with a variable-rate obligation. A financial intermediary collects interest payments from each party and "swaps" them between the two parties while taking a small cut for itself.
Determine the notional amount of the debts. The term "notional amount" simply refers to the principal amount of the loans, which should always be identical.
Determine the interest rates of the fixed- and variable-rate debts. The fixed-interest rate will be clearly defined. Estimate the future interest rates of the variable loan by constructing a yield curve associated with the benchmark used in calculating the variable rate. According to Investopedia.com, the London Interbank Offered Rate (LIBOR) is often used as a benchmark for setting variable interest rates.
Calculate the actual interest payments for each loan. Use the estimated interest rates for the variable loan to determine the actual interest payment amounts for each period by multiplying the interest rates by the notional amount. Multiply the stated interest rate for the fixed-rate obligation by the notional amount to determine the fixed-rate payments.
Calculate the discount factor for each payment period. The discount factor can be calculated using values from the yield curve obtained in step 2. Use the following formula to find the discount factor for each payment period, assuming that R = the current period's interest rate and N = the total number of payment periods:
1 / (1+R) ^ N
Calculate the present value (PV) of each interest payment that will be made. Multiply each interest payment amount by the discount factor for the corresponding payment period to determine the PVs.
Sum the PVs for both debts. Make sure that you have included every payment period until the maturity of the loans to arrive at an accurate figure.
Find the difference between the two summed PVs. This value is the swap spread, or the value of the interest rate swap.
Interest rate swaps are speculative investments that carry a great deal of risk, and should only be performed by experienced financial professionals.
Tips and warnings
- Interest rate swaps are speculative investments that carry a great deal of risk, and should only be performed by experienced financial professionals.