When valuing an interest rate swap from the perspective of the Fixed-Payer, why do we need to calculate the Fixed Rate Payment in between the payment dates?
For example, I enter into a 2 year Payer Interest Rate Swap with Semiannual floating rate payments based on LIBOR and fixed-rate payments based on an annual rate of 2.75%, when valuing this swap after 1 year, why do I need to re-calculate the fixed rate payment again with the new set of LIBOR rates?
By calculating the new fixed-rate based on the new LIBOR rates after 1 year to compare against the existing 2.75% swap that I’m currently holding, would this mean that the calculation method is the same for both the fixed and floating legs?
In the problem that I’m confused about, they used the discount factor method (e.g. [1-Z4]/[Z1 + Z2+ Z3+ Z4] ) to calculate the new fixed rate…why do they do this?
Makes no sense to me.
First of all, There are only 2 periods left, not 4.
Secondly, they’re doing it wrong. You figure out the value of the fixed-rate bond equivalent to the fixed leg (discounting the known payments at the new LIBOR rates), and the value of the floating-rate bond equivalent to the floating leg (by discounting the known next payment and par using the new LIBOR rate), then subtract.
That’s what I thought too…it seemed wierd to be calculating the new Fixed rate 1 year later, but in the explanation, the investor that was in a pay-swap position had to compare it against the new Fixed Rate under the new set of LIBOR-rates.
It just so happened that the new fixed rate was less than the 2.75% that he was paying, so in a sense, the swap had negative value to that investor?
I’m so confused, it just unravelled everything I learned about plain vanilla interest rate swaps for a moment…I think I should probably just ignore this problem since it is too confusing.