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There seems to be two different methods I have come across for valuing a Interest Rate Swap - specifically the floating leg.

One method described by Hull: incorporates the cashflow from the first known floating leg payment, then immediately after this adds in 100 to the cashflow - To represent a fairly priced bond.

Another method actually uses the forward rate as the expectation of what the swap rate will be.

Opinions/explanations on these methods?

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The first method assumes that the value of a floating leg at libor flat is 100. This contains an inbuilt assumption that the discount rate is Libor flat, which is an assumption that used to be made. Nowadays , we discount cash flows at Fed Funds (or Eonia in Europe), so the second method is better: first replace the floating rates by their forward rates, then discount at Fed Funds.

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  • $\begingroup$ for the 2nd method, if i thought rates along the swap would be lower than the forward rate used to price the swap, could I potentially make money if i bought a swap, pay floating? I know forward rates incorporate a risk free growth premium, but it seems odd to price the floating leg like this - but I suppose that it is a risk-neutral pricing method so it holds? I'm guessing a lot of HFs will take a view and look to make arbitrage using swaps? $\endgroup$ – user6046760 Jul 9 at 12:40
  • $\begingroup$ Indeed. Replacing the rates by their forwards is a risk neutral pricing method. And receiving fixed/paying floating on a swap is a way to speculate on lower rates. $\endgroup$ – dm63 Jul 10 at 3:49

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