An interest rate swap is an agreement between two parties to swap cash flows arising from interest on loans that are similar in amount but different in their other terms. A typical interest rate swap might be an agreement between one party that has taken out a loan with a variable interest rate and another that has a loan with a fixed interest. The interest rate swap valuation at a particular time is the difference in the current value of the two future income streams. This value will be an asset for one of the parties and a liability for the other.
The swap enables each the parties to exploit their comparative advantage in their own segment of the financial markets. For example, companies that have a high credit rating might have a comparative advantage in raising long-term funds at fixed rates. A borrower who has a lower credit rating might therefore wish to take out a variable rate loan and enter into an interest rate swap to achieve certainty of cash flows into the future.
The periodic payments made under the swap agreement are net payments from one party to the other. The payments represent the difference in the amounts of interest payable on the loans. The payment is made by the party with the greater obligation to the party with the lesser obligation based on the net difference in the amounts of interest payable.
The interest rate swap valuation at any point can be found by comparing the current value of the two legs of the interest rate swap. For example, in an interest rate swap consisting of a fixed rate leg and a floating rate leg, the fixed rate leg's future amounts and dates of payment are known. The current value of the payments on the fixed rate loan can therefore be calculated from the data available.
The future payments on the variable rate leg of the interest rate swap are not known, because they depend on the future movements in the variable interest rate on the loan. The forward interest rates in relation to the variable rate loan, however, can be derived using the yield curve in relation to the loan. The yield curve is a graph showing the interest rates on the loan at different periods to the maturity of the loan, computed on the basis of market data. Using the future payment stream calculated using these forward rates, it is possible to compute the current value of the income stream on the variable rate loan.
The final step in the interest rate swap valuation is to compare the current value of the two legs of the loan. The difference between the two is the current value of the interest rate swap. This interest rate swap valuation will be included in the financial statements as a liability for one of the parties and an asset for the other party.