1 Background

When borrowing money, the borrower pays interest to the lender to compensate for the use of the
money. The interest rate that is charged on the loan may be a fixed interest rate or a variable
interest rate. A fixed interest rate is a rate that is determined at the time of the loan and will not
change during the term of the loan even if interest rates in the market change. This means that
the borrower and the lender can agree to a repayment schedule that will not change over the term
of the loan. For example, ABC Life Insurance Company borrows 10 million that will be repaid at
the end of five years. ABC will pay 6% interest at the end of each year. In this example, the
interest rate is a fixed interest rate of 6% and the annual interest payment is 600,000.
For other loans, the interest rate on the loan will be variable. A variable interest rate is adjusted
periodically, upward or downward, to reflect the level of market interest rates at the time of the
adjustment. The procedure for adjusting the interest rate will be specified in the loan agreement.
A variable interest rate is often referred to as a floating interest rate, which is a synonymous
term.
For example, DEF Life Insurance Company borrows 10 million that will be repaid at the end of
five years. DEF will pay interest on the loan at the end of each year. The interest rate on the loan
will be adjusted each year. The interest rate to be paid will be the one-year spot interest rate 1 at
the beginning of the year. Thus, the annual interest payment on the loan could change each year.
Unlike the loan to ABC where the interest rate is known for all five years at the time that the loan
is initiated, the interest rate on the loan to DEF is known for only the first year at the time that
the loan is initiated. Therefore, the interest rate that DEF will pay in years two through five may
be greater than or less than the interest rate in the first year.
Most bank loans to corporations or businesses, as well as some home mortgage loans, contain a
variable interest rate. Most of the time, the interest rate to be charged is linked to an outside
index. The most common indexes used are the London Inter-Bank Offered Rate (LIBOR) and
the prime interest rate.
LIBOR is the interest rate estimated by leading banks in London that the average leading bank
would be charged if borrowing from other banks. LIBOR rates are calculated for five currencies
and seven borrowing periods ranging from overnight to one year. The prime interest rate is the
rate at which banks in the U.S. will lend money to their most favored costumers and is a function
of the overnight rate that the Federal Reserve will charge banks. The Wall Street Journal surveys
the 10 largest banks in the U.S. and daily publishes the prime interest rate.
The variable interest rates charged on the loans are typically one of the above indexes plus a
spread. For example, the variable interest rate may be LIBOR plus 2.5%. This is typically

1
A spot interest rate is the annual effective market interest rate that would be appropriate to determine the present
value today of a single payment in the future. You may already know about spot rates from your other exam studies.
If not, spot interest rates are discussed in detail in Section 3.

2
expressed in term of basis points or bps. A basis point is 1/100 of 1%. Therefore, the above rate
would be LIBOR plus 250 bps. The spread is negotiated between the borrower and the lender.
The spread is a function of several factors, such as the credit worthiness of the borrower. The
spread will be larger if the credit risk associated with the borrower is greater.
In the loan to DEF above, the interest rate can change annually. The period of time between
adjustments of the interest rate does not need to be a one-year period. It could be reset more
frequently, such as every 90 days.
A loan with a variable interest rate adds a level of uncertainty (and potentially risk) to the loan
that a borrower may want to avoid. An interest rate swap can be used to remove this uncertainty.
However, a party that has income based on the current level of interest rates, may prefer to have
a variable interest rate. This would result in a better matching of income with the expected loan
payments, which would reduce the risk for the party. In that case, if the party has a fixed rate
loan, they may enter into a swap to change the fixed rate into a variable rate.

2 Definitions
An interest rate swap is an agreement between two parties in which each party makes periodic
interest payments to the other party based on a specified principal amount. One party pays
interest on a variable rate while the other party pays interest on a fixed rate. 2
The fixed interest rate is known as the swap rate. 3 We will use the symbol R to represent the
swap rate. The swap rate will be determined at the start of the swap and will remain constant for
each payment. In contrast, while the variable interest rate will be defined at the start of the swap
(e.g., equal to LIBOR plus 100 bps), the rate will likely change each time a payment is
determined.
The two parties in the agreement are known as counterparties. The counterparty who agrees to
pay the swap rate is called the payer. The counterparty who agrees to pay the variable rate, and
thus receive the swap rate, is called the receiver.
The specified principal amount is called the notional principal amount or just notional
amount. The word “notional” means in name only. The notional principal amount under an
interest rate swap is never paid by either counterparty. Thereby, it is principal in name only.
However, the notional amount is the basis upon which the exchange of payments is determined.
One counterparty will owe a payment determined by multiplying the swap rate by the notional
amount. The other counterparty will owe a payment determined by multiplying the variable
interest rate by the notional amount.
The specified period of the swap is known as the swap term or swap tenor.

2
Interest rate swaps can exchange one variable interest rate for another variable interest rate. However, such swaps
will not be covered by this study note.
3
Swap rates are monitored and published daily just as the prime interest rate mentioned above. The swap rate varies
daily or even within a day.

3
An interest rate swap will specify dates during the swap term when the exchange of payments is
to occur. These dates are known as settlement dates. The time between settlement dates is
known as the settlement period. Settlement periods are typically evenly spaced. For example,
settlement periods could be daily, weekly, monthly, quarterly, annually, or any other agreed upon
frequency. The first settlement period normally begins immediately with the first payment at the
end of the settlement period. For example, if the settlement period is every three months, then the
first swap payment is made at the end of three months.
In Section 1, we introduced the concept of variable rate loans. An interest rate swap can be used
to change the variable rate into a fixed rate. In this case the borrower would enter into an interest
rate swap with a third party. Entering into a swap does not change the terms of the original loan.
A swap is a derivative instrument that is used to exchange variable rate payments for fixed rate
payments.
However, two parties can enter into an interest rate swap without any loan being involved. One
reason for doing this is speculation. One counterparty is “betting” that the variable rates are
going to increase from current expectations while the other counterparty is betting that the
variable rates are going to decrease. Other reasons include managing the duration of a portfolio
or to swap a series of cash flows linked to interest rates, but where the cash flows are not from a
loan.
At the time that each exchange of payments is to occur, the two payments are netted and only
one payment is made. For example, Tyler and Graham enter into an interest rate swap. Based on
this swap, at the end of one year, Tyler owes Graham 32,000 and Graham owes Tyler 27,000.
Rather than each counterparty making a payment, the two payments would be netted and Tyler
would pay Graham 5,000. This is known as the net swap payment.
The vast majority of interest rate swaps have a level notional amount over the swap term.
However, this is not always the case. For example, a swap could have a notional amount that
follows the outstanding balance of an amortization loan. Such a swap is known as an amortizing
swap as the notional amount is decreasing over the term of the swap. Similarly, a swap could
have a notional amount that increases over time. This is known as an accreting swap. 4
A swap typically has the first settlement period beginning at time zero. However, a swap could
be a deferred swap. For deferred swaps, the exchange of payments does not start until a later
date. An example is a swap where settlements occur quarterly over a three year period, but the
first settlement period does not start for two years. This means that the first exchange of
payments will be at the end of two years and three months because settlement occurs at the end
of the settlement period that starts at time 2 and ends at time 2.25. With a deferred swap, the
swap rate R is determined at the time that the swap is initiated even though the first payment will

4
A reason for an accreting swap is that a business is expecting rapid growth over the swap term and expects to need
additional debt capacity as the growth occurs.

4
not occur until after the deferral period. The swap term or swap tenor for a deferred swap
includes the deferral period. For the example in this paragraph, the swap term would be five
years.
There is no cost to either counterparty to enter into an interest rate swap. 5 This is because the
swap rate is determined such that the expected future payments for each counterparty has the
same present value. This will be our basis for determining the swap rate, R. Since the actual
payments are netted as noted above, this results in the present value of the net payments that each
counterparty is expected to receive in the future being equal to zero.
It should be noted that in practice customized swaps may not have a value of zero at inception, in
which case a premium would be paid by one counterparty to the other counterparty. However,
for the purpose of this study note, we assume the present value of the swap is always zero at
inception.
Example 1
Jordan Corporation has borrowed 500,000 for the next two years at a variable interest rate. Under
this loan, Jordan will pay interest at the end of year one and at the end of year two. The interest
that Jordan will need to pay at the end of the first year is based on the one-year spot interest rate
at the start of year one (time zero). The interest to be paid at the end of the second year will be
based on the one-year spot interest rate at the beginning of the second year (time one). As
mentioned above, the one-year spot interest rate that Jordan Corporation will have to pay will
likely be related to LIBOR or the prime rate. These negotiated or agreed upon rates would be
used in our calculation. However, for simplicity of language throughout this study note, we will
use the term spot interest rate without worrying about how it would be specifically defined in the
swap or loan agreement.
The current spot interest rates are an annual effective interest rate of 5% for a one-year period
and an annual effective interest rate of 6% for a two-year period. These spot interest rates will be
used to calculate present values. From this we know that the interest rate for the first year of the
loan is 5%. However, we do not know what the interest rate will be during the second year of the
loan because it will be whatever the one-year spot interest rate is at the beginning of the second
year. Based on the spot interest rates today, we can calculate the implied one-year spot interest
rate that will be in effect during the second year. This is also known as the forward interest rate
for the period from time one to time two. We will refer to this rate as the one-year forward rate
(since it covers a period of one year from time one to time two), deferred one year (since it
comes into effect one year in the future). The implied rate for the second year is 7.01%. 6

5
This statement assumes that there are no transaction costs involved in the swap. For the purpose of this study note,
transaction costs will be ignored or assumed to be zero.
2

6 1.06
This is calculated as − 1 = 0.07010 = 7.010% . This will be explained in detail in Section 3. For the current
1.05
1

discussion, just use the 7.010% interest rate for the sake of the example.

5
However, under this loan, the interest rate for the second year could be higher or lower than
7.01% depending on the interest rates in one year.
Jordan Corporation is not comfortable with the uncertainty of the second year interest rate so it
wants to enter into an interest rate swap that will fix the interest rate for the two years. Using our
defined terms from above, the swap term or tenor is two years. The settlement periods are one
year with settlement dates at the end of one year and at the end of two years. Jordan Corporation
is one of the counterparties. The other counterparty is not specifically known in this example.
Under the swap, Jordan will pay a fixed interest rate of R during both years of the loan. To find
the swap rate R, we set the present values of the interest to be paid under each loan equal to each
other and solve for R. In other words:
The Present Value of interest on the variable rate loan =
The Present Value of interest on the fixed rate loan.
Under the variable loan interest rate, the interest to be paid in the first year is 500,000(0.05).
Further, based on today’s interest rates, the interest to be paid at the end of the second year is
expected to be 500,000(0.07010). For the fixed rate loan, the interest to be paid at the end of the
first year and at the end of the second year is 500,000(R). Setting the present value (using the
current spot rates) of each of these interest streams equal to each other, we get:
500, 000(0.05) 500, 000(0.07010) 500, 000( R) 500, 000( R )
+ = + .
1.05 1.062 1.05 1.062
Solving gives R = 0.05971. Therefore, if Jordan Corporation entered into a swap, the fixed
interest rate that Jordan would pay is 5.971% for the tenor of the swap.

3 General Formula
We will now develop a framework for deriving the swap rate R.
Let rt be the spot interest rate for a period of t years. The spot interest rate, rt , is expressed as
an annual effective interest rate but t does not need to be an integer. The spot interest rate is the
market interest rate today that would be appropriate to determine the present value today of a
single payment at time t. Using the spot interest rate, a payment of one at time t has a present
value of (1 + rt ) − t at time zero. As noted above, t is always measured in years.

Now let Pt be the present value of a payment of one at time t. By definition, Pt = (1 + rt ) − t .

Theoretically, spot interest rates are determined using the price of a zero-coupon bond.
Remember that a zero-coupon bond has no coupons and therefore has a single cash flow that is
the maturity value payable at the maturity date. If a zero-coupon bond matures in t years for a
maturity value of 1, then the price of the bond is the present value of the maturity value, which is
(1 + rt ) − t or Pt . Therefore, Pt is also the price of a zero-coupon bond that matures for 1 at the end
of t years. In practice, except for the zero-coupon bonds issued by governments, there may not be

6
zero coupon bonds available in the market to use to determine the appropriate spot interest rates
for a loan. In this case the spot interest rates can be implied from other financial instruments in
the marketplace.
To determine the swap interest rate, we also need to know the implied interest rates in the future.
These interest rates, known as forward interest rates, are implied by the spot interest rates. 7 We
will let f[t1 ,t2 ] be the implied interest rate between times t1 and t2 based on the spot interest rates.
As with spot interest rates, forward interest rates are expressed as annual effective interest rates
and times t1 and t2 are measured in years. For example, f[2,3] is the interest rate from time two
to time three, which is the third year. Similarly, f[0.25,0.75] is the annual effective implied interest
rate for the six-month period beginning at the end of three months.
There is a relationship between forward rates and spot rates that can be seen in the following
diagram.

rt1 f[t1 ,t2 ]

0 t1 t2

rt2

If these interest rates are to be equivalent, then we can develop the formula:
t2 t1 t2 −t1
1 + rt2 = 1 + rt1 1 + f[t1 ,t2 ] . (3.1)
Rearranging leads us to the following two important relationships:
t2
t2 −t1 1 + rt2
1 + f[t1 ,t2 ] = t1
(3.2)
1 + rt1

and

7
Alternatively, forward interest rates can be derived from the price of futures contracts. For example, the Eurodollar
futures contract provides a series of three month forward rates implied by LIBOR. From these forward rates, we can
derive spot rates and the implied price of a zero coupon bond.

7
 1
 1+ r t2
 t2 −t1
= 
t2
f[t1 ,t2 ] − 1. (3.3)
 t1 
1 + rt1
 
Formula (3.3) expresses the annual forward interest rate for the period. We also need to know
the periodic effective forward interest rate for the settlement period, where the length of the
interest rate period is the length of the settlement period. We will use the symbol f[*t1 ,t2 ] to
represent this rate and refer to it as the effective forward interest rate for the settlement period.
Then,
t2
1 + rt2
1 + f[*t1 ,t2 ] = t1
(3.4)
1 + rt1

and
t2
1 + rt2
f[*t1 ,t2 ] = t1
− 1. (3.5)
1 + rt1

It should be noted that these relationships and the derivation of forward interest rates is based on
the assumption of no arbitrage. The concept of no arbitrage is outside the scope of this study
note.
Example 2
Let us work through an example to better understand the relationships between spot interest rates
and forward interest rates. Start with the spot interest rates in Table 1.
Table 1
Spot Interest Rates
t rt t rt
0.25 1.00% 1.75 2.05%
0.50 1.10% 2.00 2.40%
0.75 1.22% 2.25 2.75%
1.00 1.35% 2.50 3.05%
1.25 1.50% 2.75 3.30%
1.50 1.75% 3.00 3.50%

8
First, use the above spot rates to determine the one-year forward rate, deferred two years. This
would be the implied interest rate for the third year. This will be
1
 (1 + r3 )3  3−2 (1.035)3
f[2,3] = 2 
−1 = − 1 = 0.05736 = 5.736% .
 (1 + r2 )  (1.024)2

In words, this is the implied annual effective interest rate for the period from time two to time
three. In this case, f[2,3] = f[2,3]
*
. Remember that f[*t1 ,t2 ] is the effective interest rate for the period
from time t1 to t2 . However, because in this case the period we are considering is a one-year
period, the effective interest rate for the one-year period is the annual effective interest rate.
Whenever we find the forward interest rate for a one-year period, that is t2 − t1 = 1 , then
f[t1 ,t2 ] = f[*t1 ,t2 ] . We can also see that Formula (3.3) above is equal to Formula (3.5) when
t2 − t1 = 1 .

Now, let us look at the period from time 2 to time 2.25. Using the spot interest rates, the forward
rate is
1
4
 (1 + r2.25 ) 2.25  2.25− 2  (1.0275) 2.25 
f[2,2.25] =  − 1 =   − 1 = 0.05593 = 5.593% .
 (1 + r2 ) 
2 2
 (1.024) 
This is the annual effective interest rate being earned during this three-month period. If we want
the effective rate for the 3 months, then the rate is

 (1 + r2.25 ) 2.25   (1.0275) 2.25 

*
f[2,2.25] =  − 1 =   − 1 = 0.01370 = 1.370% .
 (1 + r2 ) 
2 2
 (1.024) 
*
Note here that f[2,2.25] and f[2,2.25] are also related as (1.05593) 0.25 = 1.01370 .

To complete our framework, we will define Qt to be the notional amount for the settlement
period ending at time t where t is measured in years. While the notional amount is generally level
(meaning Qt is a constant), this does not have to be the case. If we have a three-year interest rate
swap where the floating rate resets annually, then we could have a notional amount of one
million the first year, two million the second year, and three million the last year. In this case,
Q1 = 1, 000,000 while Q2 = 2, 000, 000 and Q3 = 3, 000, 000 .

Using the above defined symbols and the fact that the counterparties both have the same present
value of interest to be paid at time 0, we can find the swap rate using the following formula:
The present value of the interest to be paid on the variable interest rate loan =
The present value of the interest to be paid on the fixed interest rate loan.

9
That is,
n n n
∑ Qti f[*ti −1,ti ] Pti = ∑ Qti ⋅ R ⋅ Pti = R ∑ Qti Pti , (3.6)
i =1 i =1 i =1

which implies
n
∑ Qt i
f[*ti −1 ,ti ] Pti
R= i =1
n
. (3.7)
∑ Qt Pt i i
i =1

Example 3
We will now find the swap rate for Example 1 using Formula (3.7):
n
∑ Qt i
f[*ti −1 ,ti ] Pti *
Q1 f[0,1] *
P1 + Q2 f[1,2] P2
i =1
R= =
n
Q1P1 + Q2 P2
∑ Qt Pt i i
i =1

(500, 000)(0.05)(1.05) −1 + (500, 000)(0.0701)(1.06) −2

= = 0.05971 = 5.971%.
(500, 000)(1.05) −1 + (500, 000)(1.06) −2
Note that we get the same answer as we did in Example 1. Also, we see that when the notional
amount is level, we can cancel the notional amount out of both the numerator and the
denominator.
Example 4
Now let’s work an example where the notational amounts are not level. Above, we discussed a
three-year interest rate swap where the floating rate resets annually with a notional amount of
one million the first year, two million the second year, and three million the last year. This is an
accreting swap with a three-year term and annual settlement periods. We will now find the swap
rate using the spot interest rates in Table 1. In this case, Q1 = 1, 000,000 while Q2 = 2, 000, 000 ,
and Q3 = 3, 000, 000 . We will also need to calculate the forward interest rates. First,
1
1 + r1 (1 + 0.0135)1
*
f[0,1] = 0
−1 = − 1 = 0.0135.
1 + r0 1

We note here that the forward rate from time 0 to time 1 is the same as the spot rate for a one-
year period. This should make sense given the definitions since both definitions state that this is
the interest rate for the period from time 0 to time 1. We next have,

10
 2
1 + r2 (1 + 0.0240) 2
f *
[1,2] = −1 = − 1 = 0.03461
1 + r1
1
(1 + 0.0135)1

and

(1 + r3 ) 3 (1.035) 3
*
f[2,3] = − 1 = − 1 = 0.05736.
(1 + r2 ) 2 (1.024) 2

Then,
n
∑ Qt i
f[*ti −1 ,ti ] Pti *
Q1 f[0,1] *
P1 + Q2 f[1,2] *
P2 + Q3 f[2,3] P3
i =1
R= =
n
Q1P1 + Q2 P2 + Q3 P3
∑ Qt Pt i i
i =1

(1, 000, 000)(0.01350)(1.0135) −1 + (2,000, 000)(0.03461)(1.024) −2 + (3, 000,000)(0.05736)(1.035) −3

=
(1, 000, 000)(1.0135) −1 + (2, 000, 000)(1.024)−2 + (3, 000, 000)(1.035) −3
= 0.04188 = 4.188%.

4 Special Formula
Next we will develop a formula that we can use to derive the swap rate, R, for any interest rate
swap provided that the notional amount is level for each settlement period. In other words, this
formula will work as long as Qt is constant. This formula is useful because, as mentioned earlier,
the vast majority of interest rate swaps have a constant notional amount.
1 1
First, note that Pt = (1 + rt ) − t = → (1 + rt )t = .
(1 + rt ) t
Pt
t2
1 + rt2 Pt1
Second, note that f[*t1 ,t2 ] = t1
−1 = − 1.
1 + rt1 Pt2

Then,
n n
∑ Qti f[*ti −1 ,ti ] Pti ∑ f[*t P
i −1 ,ti ] ti
i =1 i =1
R= n
= n
, because Qti is a constant,
∑ Qt Pt i i ∑ Pt i
i =1 i =1

11
and finally,
n   Pt  
∑  P
n
i −1
 − 1 Pti ∑ Pti −1 − Pti
i =1   ti   i =1
R= n
= n
∑ Pti ∑ Pt i
i =1 i =1
Pt0 − Pt1 + Pt1 − Pt2 + Pt2 − Pt3 +  + Ptn −1 − Ptn
= n
(4.1)
∑ Pt i
i =1
Pt0 − Ptn
= n
.
∑ Pt i
i =1

If the interest rate swap starts immediately (is not a deferred swap), then Pt0 = P0 = 1 because the
present value of 1 payable today is 1. Under that circumstance, then Formula (4.1) simplifies to:
1 − Ptn
R= n
. (4.2)
∑ Pt i
i =1

Example 5
We will now calculate the swap rate of Example 1 using Formula (4.2):
1 − Ptn 1 − P2 1 − (1.06) −2
R= = = = 0.05971 = 5.971%.
n
P1 + P2 (1.05) −1 + (1.06) −2
∑ Pt i
i =1

This formula can save considerable time if we are given spot interest rates as we do not need to
actually calculate forward interest rates.
As discussed in Section 3, spot interest rates may be determined using the price of zero-coupon
bonds. Further, as we also demonstrated, Pt can also be viewed as the price of a zero-coupon
bond maturing for an amount of 1 at time t. Formula (4.2) is especially useful if we want to
calculate the swap rate using the price of zero-coupon bonds. In that case, we do not need to
determine the spot interest rates or the forward interest rates, we can just directly calculate the
swap rate R.
Example 6
In this example, Jenna has borrowed 250,000 to be repaid at the end of three years. Under the
loan, Jenna will pay a floating interest rate based on the one-year spot interest rate at the start of
each of the next three years. Jenna wants to swap the floating rate for a fixed rate.

12
Further, we have the following prices for zero-coupon bonds with a maturity value of 1:
Table 2
Prices of Zero-Coupon Bonds
Maturity Date Price
1 Year 0.96
2 Years 0.91
3 Years 0.85
4 Years 0.79
5 Years 0.72

Using this information, we can quickly calculate the swap rate as

1 − Ptn 1 − P3 1 − 0.85
R= = = = 0.05515 = 5.515% .
n
P1 + P2 + P3 0.96 + 0.91 + 0.85
∑ Pt i
i =1

If zero-coupon bond prices are readily available in the financial markets, using this information
in combination with Formula (4.2) makes calculations quick and easy.
Example 7
We mentioned above that while not common, it is possible to have a deferred swap. Provided
that the notional amount of the swap is level, we can use Formula (4.1). The CHI Corporation
has entered into a five-year loan agreement that permits it to borrow two million for the next five
years. Under the loan agreement, CHI will pay an annual effective interest rate of 5% for the first
two years of the loan. For the last three years of the loan, the interest rate is a floating rate that
will change annually and be equal to the one-year spot rate at the beginning of years three, four
and five. CHI wants to swap the floating interest rate during the last three years of this loan for a
fixed interest rate. CHI will achieve this objective by using a deferred interest rate swap.
Assuming the zero-coupon bond prices in Table 2, we want to calculate the fixed interest rate
that CHI will pay under the swap agreement. Using Formula (4.1),
Pt0 − Ptn P2 − P5 0.91 − 0.72
R= = = = 0.08051 = 8.051% .
n
P3 + P4 + P5 0.85 + 0.79 + 0.72
∑ Pt i
i =1

5 Net Payments
An interest rate swap is an exchange of payments where one counterparty pays interest based on
a variable interest rate while the other counterparty pays interest based on a fixed interest rate.
However, as noted previously, rather than both counterparties making payments, the payments
under the swap are “netted” meaning that only the difference between the payments (the net
swap payment) is made by one counterparty to the other counterparty.

13
Example 8
Chloe and Madison enter into a two year interest rate swap. Under the swap, Chloe will pay a
fixed rate on a notional amount of 500,000 while receiving payments based on a floating interest
rate. The swap rate is 3.5% with annual settlement periods. The floating rate is LIBOR plus 25
basis points. The LIBOR rate for the first year is 3.1% and for the second year it turns out to be
3.7%. Determine the net swap payment that will occur between Chloe and Madison at the end of
the first year and at the end of the second year.
At the end of the first year, Chloe will pay the fixed rate while Madison will pay the floating
rate. Therefore, Chloe would pay (500,000)(0.035) = 17,500. Since Madison is paying the
floating rate, she will pay (500,000)(0.031 + 0.0025) = 16,750. These two payments would be
netted so the net swap payment would be 17,500 – 16,750 = 750 from Chloe to Madison.
At the end of the second year, Chloe would again pay (500,000)(0.035) = 17,500 as the fixed rate
has not changed. Since Madison is paying the floating rate, she will pay (500,000)(0.037 +
0.0025) = 19,750. These two payments would be netted so the net swap payment would be
19,750 – 17,500 = 2,250. This time the net swap payment would be paid by Madison to Chloe.
If one of the counterparties to the swap has a loan, then the net swap payment combined with the
interest that the counterparty must make on the loan results in a net interest payment on the
loan. The net interest payment is the interest paid on the loan plus any net swap payment made
by the loan holder less any net swap payment received by the loan holder.
Example 9
We extend Example 8, so that in addition to the swap, Chloe also has a 500,000 loan from
Anderson Bank, which charges a floating interest rate of LIBOR plus 25 basis points. Calculate
the net interest payment required by Chloe at the end of each of the two years.
At the end of the first year, Chloe must pay Anderson Bank the interest based on the floating
rate. Therefore, Chloe must pay Anderson Bank (500,000)(0.031 + 0.0025) = 16,750. We also
know from Example 8 that Chloe must pay 750 to Madison at the end of the first year. Therefore,
Chloe’s net interest payment is 16,750 + 750 = 17,500.
At the end of the second year, Chloe must again pay Anderson Bank the interest based on the
floating rate, which would be (500,000)(0.037 + 0.0025) = 19,750. We also know from Example
8 that Chloe will receive a payment of 2,250 from Madison at the end of the second year.
Therefore, Chloe’s net interest payment is 19,750 – 2,250 = 17,500.
We note that in both years, Chloe’s net interest payment is 17,500. Since Chloe has swapped the
floating interest rate on the loan with Anderson Bank for a fixed interest rate, we should expect
the interest paid to be the same in both years. Also, note that the net interest payment is equal to
(500,000)(0.035) = 17,500. That is, the net interest payment is just the amount of the loan
multiplied by the fixed interest rate. This will be true as long as the notional amount of the swap
is equal to the amount of the loan and the floating rate on the loan is the same as the floating rate
being swapped.

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6 Market Value
A position in an interest rate swap can be sold or closed 8 by one of the counterparties at any time
during its swap term for its market value. The market value, ignoring transaction costs, is the
present value of the expected future cash flows under the swap. The present value is calculated
using the spot interest rates at the time of determining the market value. The spot interest rates
are likely to be different than the spot interest rates at the time that the swap rate was determined.
First, note that the market value of the swap for either counterparty is zero at the time that the
swap rate is determined. By definition, the present value of the expected future cash flows is zero
at that time.
Secondly, note that the market value at any time after the swap commences can be positive or
negative. If the present value of the future cash flows is negative, then the market value will be
negative. A negative market value means that to sell the swap, the seller would need to pay the
buyer to step into the seller’s position.
Finally, since a swap is a merely an exchange of payments between two counterparties, the
market value of the swap for one counterparty will be the negative of the market value of the
swap for the other counterparty.
Example 10
We will begin by looking at Example 1. Remember that for this example, the one-year spot
interest rate was 5% and the two-year spot interest rate was 6%. Further, we found the swap rate
to be 5.971% on a notional amount of 500,000.
Let’s assume for this example, that one year has passed. There is one year left in the swap and
we want to determine the market value of the swap. The market value will be the present value
of future expected cash flows. Both present value and the expected future cash flows are a
function of the current spot interest rates—that is the interest rates today—one year after the
swap was initiated.
Let’s calculate the market value under two interest scenarios. First, let’s calculate the market
value assuming that the one-year spot interest rate is 7.010%. We note that based on the spot
interest rate curve from one year ago, this was the implied one-year spot interest rate for time one
to time two.
Let’s calculate the market value for Jordan Corporation. Under the swap, Jordan Corporation has
to pay 5.971% interest on 500,000 at the end of the year. In return, it will receive a payment of
interest based on the one-year spot rate which is 7.010%. Therefore, the net payment to Jordan
Corporation at the end of one year will be (500, 000)(0.07010 − 0.05971) = 5195 . Then to
determine the market value, the present value will be calculated using 7.010% interest since this

8
Besides selling the swap, one way to close an interest rate swap is for one counterparty to pay the other
counterparty the market value of the swap.

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payment will be made at the end of one year, resulting in a market value of
5195 /1.07010 = 4854.69 .
Now, if the spot interest rates today are the same as they were one year ago, let’s calculate the
market value for Jordan Corporation. The one year spot rate will be an annual effective rate of
5%. Consistent with the previous calculation, the market value would be
(500, 000)(0.05 − 0.05971)
= −4623.81.
1.05
Example 11
In Example 4, we determined the swap rate for a swap with a non-level notional amount. Let’s
use this example and determine the market value at the end of one year given that the spot
interest rates at the end of one year are as follows:
Table 3
Spot Interest Rates After One Year
t rt t rt
0.25 1.50% 1.75 2.40%
0.50 1.65% 2.00 2.48%
0.75 1.79% 2.25 2.80%
1.00 1.92% 2.50 3.10%
1.25 2.10% 2.75 3.35%
1.50 2.25% 3.00 3.50%

At the end of one year, there are two years left on the swap. The notional amount of the swap at
the end of one year is two million and at the end of two years is three million and the swap rate is
4.188%. (Note that the amounts of two and three million were originally at the end of years two
and three but since one year has passed, these are the notional amounts for the next two years.)
We will determine the market value of this swap from the standpoint of the payer. This
counterparty will pay 4.188% interest on two million at the end of one year and 4.188% interest
on three million at the end of two years. In return, the payer will receive the one-year spot rate
for the next year at the end of one year on two million and the one-year spot rate during the
second year on three million. The one-year spot rate for the next year is known and is 1.92%.
The one-year spot rate for the second year is not known, but can be implied by Table 3. The one-
year forward rate, deferred one year is equal to
1 1
 1 + r2 2
 2−1  1.0248 2  2−1
f[1,2] = 1 
−1 =  1 
− 1 = 0.03043 .
 1 + r1   1.0192 

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Then the market value is the present value of the expected future cash flows:
(2, 000, 000)(0.0192 − 0.04188) (3, 000, 00)(0.03043 − 0.04188)
+ = −77, 213.08.
(1.0192)1 (1.0248) 2
Therefore, the payer will have a negative market value while the receiver will have a positive
market value of 77,213.08.

7 Conclusion
Interest swaps are valuable financial instruments. They can be used to manage the risk of future
cash flows, manage the duration of a portfolio, or create liquidity. As future actuaries, you
should now be able to not only do the calculations (swap rate, market value, cash payments
under a swap, …) but should also understand the mechanics of the swap.

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