Section 40 (Pricing and valuation of forwards) - End of Chapter Question #9

The question says that the bank entered into a 3 year fixed for floating interest rate swap 1 year ago… So when you calculate the value of the swap after one year, don’t you use the sum of the PV factors for years 2 and 3?

I thought you would calculate the value like this: V = (0.03 - 0.01) (1.943012) ($50,000,000) = $1,943,012

The sum of the PV factors I used where for years 2 and 3 (.977876 + .965136).

However, the book says the answer is : V = (0.03 - 0.01)(1.967975)($50,000,000) = $1,967,975.

They used the sum of the PV factors for years 1 and 2 (.990099 + .977876).

I don’t understand why you would use the year 1 instead of year 3? My thinking is that one year has already gone by so you wouldn’t use that PV factor, you would use the remaining 2 years PV factors. Can anyone help?

I don’t have access to this question, but i’m assuming that the discount rates (PV factors) that apply would be year 1 and year 2.

You would be using the wrong discount rates if you were to use PV factors for year 2 and year 3.

Think of it like this… the time at which you are valuing the swap (one year after swap initiation) is day one and therefore you must use the relevant rates, which would be year 1 and year 2 rates.

Hope that helps.

Read the vignette again. Carefully.

What’s remaining tenure on the swap?