Interest rate swaps valuation

The fundamental principle of valuation is that the value of any financial asset is equal to the present value of its expected future cash flows. This principle holds for any financial asset from zero-coupon bonds to interest rate swaps. Thus, the valuation of a financial asset involves the following three steps ... 

This chapter discusses the uses of interest rate swaps, including as a hedging tool, from the point of view of bond-market participants. The discussion touches on pricing, valuation, and credit risk, but for complete... 

As noted earlier,a newly transacted interest rate swap denotes calculating the swap rate that sets the net present value of the cash flows to zero. Valuation signifies the process of calculating the net present value of an existing swap by setting its fixed rate at the current market rate. Consider a plain vanilla interest rate swap with the following terms ... 

There is still a consistency problem if we want to price interest rate derivatives on zero bonds, like caplets or floorlets, and on swaps, like swaptions, at the same time within one model. The popular market models concentrate either on the valuation of caps and floors or on swaptions, respectively. Musiela and Rutkowski (2005) put it this way We conclude that lognormal market models of forward LIBORs and forward swap rates are inherently inconsistent with each other. A challenging practical question of the choice of a benchmark model for simultaneous pricing and hedging of LIBOR and swap derivatives thus arises. ... 

It is important for a zero-coupon yield curve to be constructed as accurately as possible. This because the curve is used in the valuation of a wide range of instruments, not only conventional cash market coupon bonds, which we can value using the appropriate spot rate for each cash flow, but other interest-rate products such as swaps. 

The zero-coupon curve is used in the asset swap valuation. This curve is derived from the swap curve, so it is the implied zero-coupon curve. The asset swap spread is the spread that equates the difference between the present value of the bond s cash flows, calculated using the swap zero rates, and the market price of the bond. This spread is a function of the bond s market price and yield, its cash flows, and the implied zero-coupon interest rates. ... 

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