How to Value an Interest Rate Swap

Interest rate swaps amount to exchange cash flows, with one flow based on variable payments and the other on fixed payments. To understand whether a swap is a good deal, investors need to figure the present value of both cash flows, based upon current and projected interest rates.

Step 1

Research key market variables that affect swap pricing and valuation. These include interest rate levels, swap spreads, currency swap spreads, and changes in the shape of the yield curve going out 30 years.

Step 2

http://www.interestrateswaps.info/swap_valuation.htm, Floating to Fixed Rate Interest Swap

Research transaction specific variables that might affect swap pricing and valuation. These include the national principal amount, amortization schedule, time to maturity, and the frequency of swap payments.

Step 3

Create a yield curve. Look up the market rates for treasury yields, interest rate swaps spreads and deposit rates for 1 year, 3 year, 5 year 10 year and 30 year intervals. Chart this in a spreadsheet. You might need to interpolate for missing data, but this will provide you with a basis for comparison against your own payments. Specifically, it will help to determine the forward rate for the variable side of the cash flows in the swap.

Step 4

Determine the appropriate discount factor. The discount factor is indirectly related to the yield curve. As the yield curve increases (decreases) over time, the discount factor will decrease (increase) over time. The exact formula is 1/(1+r)^n, where "r" is the interest rate and "n" is the number of periods.

Step 5

Calculate the fixed rate portion of cash flows and the variable (floating) rate portion of cash flows. That is, take the present value (PV) of cash flows using the forward rates derived in the yield curve for however many periods are in the payment. If the payment is made every 6 months, then you are looking to find the present value of cash flows every 6 months or twice a year.

Step 6

Calculate the difference between the two cash flows. This is the net present value (NPV) of the swap.

Warning

This is not to be construed as investment advice.

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