Easy Interest Rate Swap Pricing
Posted by Howard Lothrop on Wed, Apr 28, 2010 @ 10:32 AM
I like to keep things simple and easy. This includes when I want to price interest rate swaps. Here's a simple way using eurodollar futures to estimate interest rate swap rates.
Eurodollar futures are futures on three-month LIBOR. They have an interesting property that makes them extremely useful for hedging. 100 minus their price equals the spot rate of three-month LIBOR at settlement. As three-month LIBOR varies basis point for basis point, so too changes the price of each eurodollar future.
So, to estimate interest rate swap rates, all you have to do is compound up and a chain-link together these quarterly rates from the eurodollar futures. Here's an example, including an Excel spreadsheet to download.
Just enter the euro dollar futures prices in the yellow cells and the swap rates for one to 10 years are shown in the green cells. Now, of course, actual swap pricing is more complicated and exacting. For example, swaps have convexity, while eurodollar futures formulas do not. Also, adjustments would have to be made for periods not coinciding with IMM dates, day count conventions, payment frequency, and other differences. Here's a paper that offers additional insights into using euro dollar futures to price swaps.
Of course, the real test is how close the estimate comes to actual market prices. My worksheet uses yesterday's closing Eurodollar values. I compared the swap prices as estimated with the interest rate swap prices quoted by the Federal Reserve's H15 report on interest rates. The difference is slight in the 2 to 5 year sector ( 1- 8 bps), but is more pronounced in very short or very long dated swaps. I don't recommend trying to trade using a method like this, but it is still a good way to get a close approximation of interest rate swap rates.
Photo provided by David Leggett
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