Nicole Seaman

Director of CFA & FRM Operations
Staff member
Learning objectives: Explain the mechanics of a plain vanilla interest rate swap and compute its cash flows. Explain how a plain vanilla interest rate swap can be used to transform an asset or a liability and calculate the resulting cash flows. Explain the role of financial intermediaries in the swaps market. Describe the role of the confirmation in a swap transaction. Describe the comparative advantage argument for the existence of interest rate swaps and evaluate some of the criticisms of this argument. Explain how the discount rates in a plain vanilla interest rate swap are computed. Calculate the value of a plain vanilla interest rate swap based on two simultaneous bond positions.


23.7.1. Among over-the-counter (OTC) interest rate derivatives, interest rate swap contracts are the most actively traded, according to BIS (source: Further, as Libor phases out, swaps will increasingly reference overnight rates such as SOFR and SONIA. About these modern overnight indexed swap (OIS) contracts, each of the following statements is true EXCEPT which is false?

a. In contrast to LIBOR, overnight rates such as SOFR and SONIA are nearly (or effectively) risk-free rates
b. The N-year swap rate is set equal to the average yield to maturity of bonds trading with N-year maturities
c. While LIBOR rates are known at the beginning of a period, overnight rates are known only at the end of each period
d. The confirmation specifies the swap's day count convention, payment exchange dates, payment calculation methodology, and the applicable holiday calendar.

23.7.2. Secondrate Corp can borrow for five years at a fixed rate of 7.00% or at the floating rate of the floating index plus 300 basis points. Thirdrate Corp can borrow for five years at a fixed rate of 9.20% or at the floating-rate index plus 400 basis points. Their investment bank intermediary earns 20 basis points. All rates are per annum. Secondrate ultimately seeks to borrow at a floating rate, while Thirdrate prefers to borrow at a fixed rate. Both corporations seek to borrow the same amount over five years. If the intermediary designs a swap that shares the benefit equally, what is Thirdrate Corp's net borrowing rate?

a. 7.00%
b. 7.75%
c. 8.70%
d. 9.00%

23.7.3. An overnight indexed swap (OIS) with a notional of $100.0 million has four years remaining in its life. The swap receives a fixed rate of 5.50% per annum at the end of each quarter and pays the rate implied by the overnight index rate (e.g., SOFR) when compounded day-by-day during the quarter. The current quote for the four-year overnight index swap is bid 4.50, ask 4.70. The risk-free rate is 3.80% per annum with quarterly compounding. Which is nearest to the value of the swap?

a. -6.650 million
b. +831.0 thousand
c. +3.325 million
d. +7.648 million

Answers here:
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