Swap curve construction

In the previous articles we described basic swap terminology, created coupon schedules and calculated fixed and floating coupon amounts. We also present valued our cashflows and calculated forward rates from our Zero Curve. A zero curve is a series of discount factors which represent the value today of one dollar received in the future. In this article we are going to look at swap curve construction and build up the short end of our discount factor curve using LIBOR rates. 

Here are the rates we are going to use. They represent USD Libor as of November 10, 2011.

ON

0.1410%

T/N

0.1410%

1W

0.1910%

2W

0.2090%

1M

0.2490%

2M

0.3450%

3M

0.4570%

4M

0.5230%

5M

0.5860%

6M

0.6540%

7M

0.7080%

8M

0.7540%

9M

0.8080%

10M

0.8570%

11M

0.9130%

Our first step will be to calculate the start & end dates for each of our LIBOR. Our TN settles in one day, and the other rates all settle in two days. We also will need to calculate the exact number of days in each period. Keep in mind that November 12th was a Saturday so our TN rate ends on the Monday, November 14th.

libor curve

Our formula for converting rates (simple interest) to discount factors is

simple interest discount factor

Where R is our LIBOR rates and T is our time calculated by the appropriate day count convention, which in this case is Actual/360.

So our first discount factor reflecting the overnight rate is:

overnight rate

which equals: 0.999996083348673.

Bootstrapping

For our subsequent rates, they settle in the future. So when we calculate their discount factors, we will need to discount again from their settle date. See the image below to see the time frame each rate represents.

zero curve bootstrapping

Because we need the previous discount factors to calculate the next discount factor in our curve, the process is known as bootstrapping.

To calculate the discount factor for TN:

TN rate LIBOR

Which equals; 0.999988250138061 x 0.999996083348673 = 0.999984333532754

We continue the process for each time period, to build up the short end of our curve.

libor discount factors

We have shown how to convert LIBOR rates into a discount factor curve, while taking into consideration the settle dates of the LIBOR rates.

Thanks to our sister company Resolution for providing us with this series of posts.

Next Article: Building the long end of the curve using Par Swap Rates.