Title LM07 Pricing and Valuation of Interest Rates and Other Swaps IFT Notes.pdf ✅

LM07 Pricing and Valuation of Interest Rates and Other Swaps 2025 Level I Notes © IFT. All rights reserved 1 LM07 Pricing and Valuation of Interest Rates and Other Swaps 1. Introduction ........................................................................................................................................................ 2 2. Swaps vs. Forwards ......................................................................................................................................... 2 3. Swap Values and Prices .................................................................................................................................. 2 Summary ................................................................................................................................................................... 3 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM07 Pricing and Valuation of Interest Rates and Other Swaps 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction This learning module covers:  How swap contracts are similar to but different from a series of forward contracts  Valuation and pricing of swaps 2. Swaps vs. Forwards A swap contract is an agreement between two counterparties to exchange a series of future cash flows, while a forward contact is an agreement for a single exchange of value at a future date. How do Swaps work? To understand how swaps work, let us consider a 3-year plain vanilla interest rate swap with annual settlement where the fixed-rate payer pays 10% and the floating rate payer pays an interest based on MRR. Also assume that the future MRR rates at t = 0, 1, and 2 are 9%, 10%, and 11%. At times 1, 2, and 3, the two parties exchange a series of payments. The fixed rate payer makes a fixed payment of 10% and receives a floating payment based on the value of the underlying at that point in time. Here is it 9%, 10%, and 11% respectively. The payments are netted. At t=1, the fixed rate payer will make a payment of 1% of notional principal to the floating rate payer. At t=2 no cash flows will be exchanged. At t=3, the floating rate payer will make a payment of 1% of notional principal to the fixed rate payer. Similarities between FRAs and Swaps  Both FRAs and swaps allow users to lock-in a fixed rate for future. In both cases, the net difference between a fixed rate agreed upon at inception and a future MRR is used to determine cash settlement.  Both FRAs and swaps have a symmetric payoff profile.  No cash is exchanged upfront. Both have a value of 0 at initiation.  Both FRAs and swaps involve counterparty credit exposure. Differences between FRAs and Swaps  An FRA has a single settlement, which occurs at the beginning of an interest period, while a swap has periodic settlements, which occur at the end of each respective
LM07 Pricing and Valuation of Interest Rates and Other Swaps 2025 Level I Notes © IFT. All rights reserved 3 period.  A swap contract is like a series of FRAs, where each FRA has a different time to maturity. While a swap has a constant fixed rate over its life, the series of FRAs will have different fixed rates for different times to maturity. This is illustrated in Exhibit 2 from the curriculum.  Financial intermediaries often use FRAs to manage interest rate exposure. But derivative end users, such as issuers and investors, usually prefer swaps because they better match rate-sensitive assets and liabilities with periodic cash flows, such as fixed-coupon bonds, variable rate loans, or known future commitments. Calculating the Swap Rate The following example demonstrates how to calculate the swap rate. Example: Swaps as a Combination of Forwards (This is based on Example 1 from the curriculum.)