Calculation of Return for Swaps

Timothy Peterson

In this chapter we will cover the basics of how swaps work and are valued, but readers are encouraged to consult other material if they are new to swaps. Then, we will apply three different performance measurement approaches to calculate the rate of return on a swap instrument. In this case, we will assume a simple fixed-for-floating interest rate swap, but the principles presented can be applied to virtually any swap by simply adjusting discount rates, time periods, payment amounts and other inputs to the analysis.

Swaps are ideal for instruction because they are conceptually simple. A swap is just a trade, and people have been trading for thousands of years. On that basis, swaps can be considered the oldest financial transaction on earth.

Secondly, understanding how swaps work, and how performance is calculated on a swap, lends itself to numerous analogous alternative investment strategies. Swaps can be viewed as a long–short portfolio. If one leg of the swap is simply a cash payment and there is only one terminal future payment, a swap looks like a forward. If there are interim (daily) settlements of gains and losses, a swap looks like futures contract. These different