Level 1 CFA® Exam:
Pricing & Valuation of Swaps
Level 1 CFA Exam: Swaps Valuationstar content check off when done
Valuation of swaps:
- At initiation, a swap usually has a zero value.
- However, during its life, a swap can have a zero, negative, or positive value, depending on the changes in market values.
Plain Vanilla Swap
A plain vanilla swap is a basic interest rate swap for which we agree to exchange some known fixed rate for unknown floating rates. For each payment date, the value of the floating rate is derived from the market. If, for example, market interest rates go up, the party that pays the fixed rate (the long) and receives the floating rates will expect to receive higher values in the future. Because at initiation the value of the swap was 0 (it’s a forward commitment), the increase of interest rates will lead to a higher (positive) value of the swap to the party that goes long. Of course, then the value for the short will be negative.
Swaps Replication Using Off-Market Forwards
Both forwards and swaps usually have a zero value at initiation. However, there might be exceptions, e.g. off-market forwards are defined as forwards with nonzero values at initiation. This kind of forward is rather uncommon but is sometimes created.
We can replicate a swap contract with a series of forward contracts with different expiration dates. However, generally forwards expiring on different dates will have different forward prices and the swap price is the same for each date. So, to be able to replicate the swap with forwards, we need to use off-market forwards – each of them will have the same forward price (equal to the swap price) and some of them will have a negative and some of them – a positive value at initiation. However, the sum of their values at initiation will be 0, the same as of the swap. So, to make a long story short:
A swap can be perceived as a series of off-market forwards with the same forward price.
Level 1 CFA Exam Takeaways for Pricing & Valuation of Swapsstar content check off when done
- At initiation, a swap usually has a zero value. However, during its life, a swap can have a zero, negative, or positive value, depending on the changes in market values.
- We can replicate a swap contract with a series of forward contracts with different expiration dates.
- A swap can be perceived as a series of off-market forwards with the same forward price.