1
$\begingroup$

the current valuation methods seem to rely on treating the floating payment as deterministic based on the current yield curve and derived forward rates. But wouldnt it make more sense to use monte carlo simulation or other methods to account for the random nature of interest rates and the fact that we will not know future floating cash flows?

$\endgroup$
2
  • 1
    $\begingroup$ Actually some parts of valuations of IRS are valued with MC. For example the exposure at default (EAD) for an assessment of the scale of risk weighted assest (RWA) from a regulatory perspective, which leads to the necessary amount of capital being held and hence the cost of kapital $\endgroup$
    – Attack68
    Feb 21 '20 at 6:24
  • 1
    $\begingroup$ Attack68 makes a good point. What is the value of an Interest Rate Swap nowadays? If you want the old-school "fair value", then you don't need Monte Carlo because the forwards are, in fact, deterministic. If you want the value of the Interest Rate Swap after all the valuation adjustments (CVA, ..., xVAs) then in some cases, you may need Monte Carlo or equivalent methods (swaptions would be enough to calculate CVA of a simple IRS...) $\endgroup$ Feb 21 '20 at 9:28
7
$\begingroup$

Forward rates are determined from current spot rates bootstrapped from traded instruments. The reason is that if the forwards were different from the ones inferred from the spot rates, there would be arbitrage.

For example, you can replicate a forward 6 month rate in 6 months with a long position in the one years rate and a short position in the 6 month rate.

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.