Page 35 - FINAL CFA II SLIDES JUNE 2019 DAY 10

LOS 39.c: Describe and compare how interest rate,
currency, and equity swaps are priced and valued. READING 39: PRICING AND VALUATION OF FORWARD COMMITMENTS
LOS 39.d: Calculate and interpret the no-arbitrage
value of interest rate, currency, and equity swaps. MODULE 39.7: PRICING AND VALUATION OF INTEREST RATE SWAPS

Currency Swaps
Determining the Fixed Rate and Foreign Notional Principal
Consider two currencies, the U.S. dollar ($) and the British pound (£), where the exchange rate is currently $2 per £ or £0.5 per $.
The interest rates in a currency swap are simply the swap rates calculated from each country’s yield curve in the relevant country’s
currency. Don’t forget: With currency swaps, there are two yield curves and two swap fixed rates, one for each currency. The
principal amounts of the fixed-rate obligations must be adjusted for the current exchange rate. We need $2.00 to equal £1.00, so
these are the notional amounts, exchanged at the inception of the swap and returned at the termination of the swap. For example, if
the notional principal amount of the $ side of the swap is $25 million, the £ notional principal amount will be £12.5 million.

Calculating the Market Value of an Interest Rate Swap

For the purpose of the exam, we are only responsible for valuation of an interest rate swap on settlement dates (after settlement
has occurred), and not between settlement dates.

After the initiation of an interest rate swap, the swap will take on a positive or negative value as interest rates change.
• The party that is the fixed-rate payer benefits if rates increase.
• Similarly, the fixed-rate receiver benefits if rates decrease.

The value is calculated as PV of the difference in payments (under the new current rate, relative to the payments under the older,
locked-in rate).

where:
ΣZΣZ = the sum of discount factors associated with the remaining settlement periods
days = number of days in the settlement period