Marking-to-market a swap is a technique for valuing it using current market prices. It involves comparing the fixed and floating payments of the swap and calculating the net present value of the difference. This gives an estimate of how much the swap is worth to one of the counterparties at a given point in time.
To mark a swap to market, one needs to know the current market rates for the underlying index of the swap, such as LIBOR or SOFR, and the discount factors for the future cash flows. The market rates are used to project the floating payments of the swap, while the discount factors are used to discount both the fixed and floating payments to the present value. The difference between the present values of the fixed and floating payments is the mark-to-market value of the swap.
For example, suppose a company entered into a 7-year swap 3 years ago, where it agreed to pay a fixed rate of 5% and receive a floating rate of LIBOR + 1.85% on a notional amount of $25 million. The swap has quarterly payments and 4 years remaining. To mark the swap to market, the company would need to find the current market rates for LIBOR for the next 4 years and the discount factors for the quarterly payments. Then, it would calculate the present value of the fixed payments by multiplying the fixed rate, the notional amount, and the discount factors for each payment date. Similarly, it would calculate the present value of the floating payments by multiplying the projected LIBOR rates, the spread, the notional amount, and the discount factors for each payment date. The difference between the two present values is the mark-to-market value of the swap.
If the mark-to-market value is positive, it means the swap is in favor of the company and it would receive a payment if it terminated the swap. If the mark-to-market value is negative, it means the swap is against the company and it would have to pay a penalty if it terminated the swap. The mark-to-market value can change over time as the market rates and expectations fluctuate.
Basic Theory:
An interest rate swap is a financial derivative where two parties exchange interest rate cash flows. One party pays a fixed interest rate, while the other pays a floating rate. The floating rate is usually based on a reference rate, such as LIBOR.
Marking-to-market a swap involves recalculating its value periodically to reflect changes in interest rates. This is crucial for both parties to understand the current fair value of the swap and to make informed financial decisions.
Procedures for Marking-to-Market a Swap in Excel:
- Gather Initial Data:
- Identify the terms of the swap: notional amount, fixed rate, floating rate index, and payment frequency.
- Determine the current market interest rates.
- Calculate Present Value of Future Cash Flows:
- Use Excel formulas to calculate the present value of future cash flows for both fixed and floating legs of the swap.
- Consider the time value of money and discount future cash flows to their present value using appropriate interest rates.
- Calculate Mark-to-Market Value:
- The Mark-to-Market value is the difference between the present value of the fixed leg and the present value of the floating leg.
Scenario Example:
Assume a notional amount of $1,000,000 for a 5-year interest rate swap.
- Fixed rate: 3%, Floating rate (LIBOR): 2.5%.
- Payment frequency: semi-annual.
Excel Calculation:
=PV(Fixed Rate/2, Years * 2, -Notional)
=PV(Floating Rate/2, Years * 2, -Notional)
=Fixed Leg PV - Floating Leg PV
For the scenario, if the fixed leg PV is $950,000 and the floating leg PV is $920,000, then the Mark-to-Market value is $30,000.
Result of the Scenario:
Mark-to-Market Value: $30,000
Other Approaches:
- Historical Marking-to-Market: Use historical market rates instead of current rates to assess changes in value.
- Monte Carlo Simulation: Simulate various interest rate scenarios to understand the potential range of Mark-to-Market values.
- Yield Curve Analysis: Consider the impact of changes in the yield curve on the swap’s value.
