An interest rate swap is an agreement to exchange interest payments, most commonly a fixed rate for a floating rate, on an agreed notional amount. Once a swap is signed, its value changes every day as floating interest rates move, and that value has to be measured for reporting, audit and risk purposes.

The core idea

A swap can be seen as two streams of cash flows, one fixed and one floating. Its fair value is the present value of the cash flows you expect to receive, minus the present value of those you expect to pay.

Everything starts with the curve

To value either stream, two things are needed: discount factors (from zero rates), which convert a future payment into today’s value, and forward rates (for example, for 3 months), which estimate the floating payments still to come. Both come from a yield curve built from live market quotes. The FBIL par rate curve or the T-Bill rate curve is generally used to prepare this. These rates can also be fetched from live terminals like Bloomberg.

Bootstrapping, in plain terms

Bootstrapping is used to build the base of the floating rate curve. It builds the curve one maturity at a time (for example, the next 3 months). The shortest instrument gives the first discount factor, from which the first zero rate is derived. That factor is then used to solve for the next tenor (say, the next 3 months), and so on. This way the zero rate curve is formed in line with the base curve, which is generally the FBIL curve representing market quotes. Interpolation fills the gaps between quoted maturities.

The bootstrapped zero rates and forward rates can also be taken from reliable market data providers like Bloomberg or Reuters, but their annual subscription does not justify even 10-15 valuation assignments.

Why your value may not match the bank’s

Sometimes, even with aggressive bootstrapping up to 15 decimal places, there may be a difference of up to 15-20% between your value and the value calculated by the client’s bank. We should therefore consider the difference in terms of the notional amount rather than the value of the swap calculated. These differences are primarily because of:

Choice of curve. Whether the bank has used the same curve as you.
Conventions. Day counts, payment calendars and reset dates change the result.
Counterparty credit. Where required, an adjustment reflects the credit risk of the counterparty.
Data quality. Stale or inconsistent market quotes lead to a wrong curve and a wrong value.

Conclusion

A reliable swap valuation supports financial reporting, lets you check the mark-to-market statements sent by a bank, and gives auditors and regulators a clear, documented basis. For funds and treasuries holding several swaps, a consistent method across all positions makes the numbers comparable from one period to the next.

This article is general information, not advice.

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