Valuation Of Derivatives (Simplified)

Hello Again and welcome to 3rd edition of the newsletter.

This newsletter is going to be technical and useful for those who are keen to learn about derivatives!

Without further ado, let me tell you today that we are going to touch on one of the basic type of derivative instruments, which is interest rate swap as how it can be valued in excel!

Let's Start!

Interest Rate Swaps

What are Interest Rate Swaps?

An interest rate swap is a financial derivative contract in which two parties agree to exchange cash flows based on a specified set of interest rates. The most common type of interest rate swap is the plain vanilla interest rate swap, in which one party agrees to pay a fixed rate of interest to the other party, while the other party agrees to pay a floating rate of interest, such as the Sterling Overnight Index Average Rate (SONIA).

Interest rate swaps are used to manage interest rate risk, as well as to take advantage of different interest rate environments. For example, a company with a floating rate debt may enter into an interest rate swap to pay a fixed rate and receive a floating rate. This can help the company manage its interest rate risk by eliminating the uncertainty associated with changes in floating interest rates.

Interest rate swaps can also be used by investors to gain exposure to different interest rate environments. For example, an investor who believes that interest rates will rise may enter into a swap to receive a fixed rate and pay a floating rate.

Interest rate swaps are typically used by large corporations, financial institutions, and governments as a means of managing and/or hedging interest rate risk, but can also be used by other entities such as investors, hedge funds, and other financial institutions.

How Interest Rate Swaps Can be Valued?

Interest rate swaps can be valued either manually in excel (based on market inputs) or through the use of market systems like Bloomberg, Reval, SuperDerivatives, Chatham, Integrity, or many more such systems.

With respect to excel, a simple Excel spreadsheet can be formed to calculate the value of an interest rate swap. You can use this basic layout.

Inputs:

• Notional amount of the swap:
• Fixed rate
• Floating rate index (e.g. SONIA, SOFR, EURIBOR, etc.)
• Tenor (length) of the swap in years
• Payment frequency (e.g. semi-annual)
• Risk Free Curves or discount factors

Outputs:

• Fixed leg payment (the amount paid by the party paying the fixed rate), determined through a product of Notional and Fixed rate adjusted for tenor and payment frequency.
• Floating leg payment (the amount paid by the party paying the floating rate), is determined through a product of Notional and Floating rate adjusted for tenor and payment frequency.
• Net payment/receipt (the difference between the fixed and floating leg payments) at each payment period
• The net payment/receipt is discounted back to present value using risk-free curves, which are determined as a product of net payment/receipt and discount factor.

This is the layout for a basic calculation, there can be further complications as the difference in payment date of fixed and floating side, additional spread on top of floating rate, impact of credit and funding risk, changing notional over the period and much more, so it is always good to consult with experts in this field.

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