An interest rate swap is an agreement between two parties to exchange cash flows derived from loans with different interest rates. The valuation of the swap is the difference in the present value of the two sources of future income, and the swap allows each party to exploit its comparative advantage in the financial markets. Periodic payments are made based on the net difference in interest amounts payable, and the valuation is found by comparing the present value of the two legs of the swap.
An interest rate swap is an agreement between two parties to exchange cash flows derived from interest on loans that are similar in amount but different in their other terms. A typical interest rate swap could be an agreement between a party that has obtained a loan with a variable interest rate and another that has a loan with a fixed rate. The interest rate swap valuation at a particular point in time is the difference in the present value of the two sources of future income. This value will be an asset for one party and a liability for the other.
The swap allows each of the parties to exploit its comparative advantage in its own segment of the financial markets. For example, companies with high credit ratings may have a comparative advantage in raising long-term funds at fixed rates. Therefore, a borrower with a lower credit rating could apply for a variable rate loan and enter into an interest rate swap to gain certainty of future cash flows.
Periodic payments made under the exchange agreement are net payments from one party to the other. The payments represent the difference in the interest amounts payable on the loans. Payment is made by the party with the higher obligation to the party with the lower obligation based on the net difference in the amounts of interest payable.
The valuation of the interest rate swap at any point can be found by comparing the present value of the two legs of the interest rate swap. For example, in an interest rate swap consisting of a fixed rate tranche and a floating rate tranche, the future amounts of the fixed rate tranche and the payment dates are known. Therefore, the present value of the fixed-rate loan payments can be calculated from the available data.
Future payments on the variable rate tranche of the interest rate swap are not known, because they depend on future movements in the variable interest rate of the loan. However, the term interest rates in connection with the variable rate loan can be derived using the yield curve in connection with the loan. The yield curve is a graph that shows the interest rates of the loan in different periods until the maturity of the loan, calculated on the basis of market data. Using the future payment stream calculated using these forward rates, it is possible to calculate the present value of the income stream on the variable rate loan.
The last step in valuing the interest rate swap is to compare the present value of the two parts of the loan. The difference between the two is the current value of the interest rate swap. This interest rate swap valuation will be included in the financial statements as a liability for one party and an asset for the other party.
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