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Unformatted text preview: Interest Rate Swaps Introduction Consider the following term structure of interest rates Years to Maturity 1 2 3 Yield Rate 4.5% 5% 6% The implied (forward) annual rates are (check it!) Year 1 Year 2 Year 3 4.500000% 5.502392% 8.028662% We want to find a fixed annual rate R % for all three years that will be equivalent to the implied annual rates above. We first turn the annual rates to money amounts by considering interest earned on $100 for each year (paid at the end of each year): Year 1 Year 2 Year 3 Interest by Implied Rate 4.500000 5.502392 8.028662 Interest by Fixed Rate R R R 1 2 3 4.500... 5.502... 8.028... R R R The two cashflows should have the same present values at t = 0 (by the term structure), so 4 . 500000 1 . 045 + 5 . 502392 1 . 05 2 + 8 . 028662 1 . 06 3 = R 1 . 045 + R 1 . 05 2 + R 1 . 06 3 (solving) = R = 5 . 932146. Therefore, the fixed rate is 5.932146%. This is the swap rate ....
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This note was uploaded on 02/27/2012 for the course FINANCE 101 taught by Professor Yuy during the Spring '12 term at Centenary College New Jersey.
 Spring '12
 yuy
 Interest, Interest Rate

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