ABSTRACT
In Chapter 5, we discuss interest rate swaps and the discount factor. An interest rate swap is an exchange of cash flows based on benchmark interest rates, and is one of the basic interest rate derivative financial instruments. In pricing derivatives, we need to know the present value of future cash flows. Future cash flows are discounted by the expected interest earned from a risk-free interest rate until maturity. The amount of discount is known as the discount factor. We can calculate the discount factor for a future cash flow from the prices of interest rate swaps of varying maturities. Finally, we discuss the calculation of risk, i.e. the sensitivity to changes in interest rates, of the interest rate swap. The analysis of risk of financial instruments is necessary for trading in financial markets.
