Fixed-rate payments calculation

The swap will specify the frequency of settlement for the fixed-rate payments. The frequency need not be the same as the floating-rate payments. For example, in the 3-year swap we have been using to illustrate the calculation of the floating-rate payments, the frequency is quarterly. The frequency of the fixed-rate payments could be semiannual rather than quarterly. 

The calculation of the swap rate for all swaps follows the same principle equating the present value of the fixed-rate payments to that of the floating-rate payments. 

A swap s fixed-rate payments are known in advance, so deriving their present values is a straightforward process. In contrast, the floating rates, by definition, are not known in advance, so the swap bank predicts them using the forward rates applicable at each payment date. The fotward rates are those that are implied from current spot rates. These are calculated using equation (7.6). 

An interest rate swap is thus an agreement between two parties to exchange a stream of cash flows that are calculated hy applying different interest rates to a notional principal. For example, in a trade between Bank A and Bank B, Bank A may agree to pay fixed semiannual coupons of 10 percent on a notional principal of 1 million in return for receiving from Bank B the prevailing 6-month LIBOR rate applied to the same principal. The known cash flow is Bank As fixed payment of 50,000 every six months to Bank B. 

In a default, the swap is terminated, and the default payment is calculated and handed over. The amount of this payment may be linked to the change in price of the reference asset or another specified asset or fixed at a predetermined recovery rate. Alternatively, it may involve actual delivery of the reference asset at a specified price. 

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