The pricing of the swap is done to calculate the swap rate of the swap. The swap rate is calculated such that both parties have zero value at the initiation of the swap contract. It is calculated based on the no-arbitrage principle.
As the time passes, the value of the swap will change due to the movement of the interest rates. For example, if two parties agree to swap the interest rates of a 5-year semi-annual floating rate bond with a fixed rate of 8 percent. One party agrees to receive 8 percent and will be ready to pay the interest rate of the floating rate bond and the other party will receive the floating interest rate and pay the fixed 8 percent. Here, the swap is priced at a swap rate of 8 percent such that the value of the contract would be zero at the initiation. But if the interest rate increases such that the floating rate payments are higher than the fixed rate payments then the swap will have a positive value for the party receiving floating rate and vice versa.
Check your concepts:
(58.13) A plain-vanilla interest rate swap (fixed-to-floating) is priced at a swap rate of 6 percent. Which party is most likely to have a positive value of the swap with an increase in the interest rates?
(a) Fixed-rate payer
(b) Floating-rate payer
(c) Swap will have the same value for both the parties
Solutions:
(58.13) Correct Answer is A: If the interest rates increase, then the fixed-rate payer will pay less interest amount and receive higher interest rate from the party that is paying the floating rate. Therefore, the fixed-rate payer will have a positive value of the swap. The floating-rate payer will have the same value but negative.
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