When investors agree to interest rate swaps, they trade their investments' terms while retaining control of their own principal. Before the swap, the buyer's principal accrues interest at a variable rate, such as the London interbank offer rate (LIBOR) or the American federal funds rate. The swap then applies a new, fixed interest rate to the investment. The swap has value to the buyer when the fixed rate ends up exceeding the variable rate. The swap's seller must then pay the buyer the difference in returns at maturity.
1. Multiply the investment's principal by the swap's fixed interest rate. For example, if you have invested $200,000 and engage in an interest swap that applies a 0.167 percent monthly interest rate on it, multiply $200,000 by 0.00167 to get $334. The investment will return $334.00 for each month of the investment's life.
2. Multiply the investment's monthly returns by the number of months until it matures. For example, if the investment matures after only two months, multiply $334 by 2 to get $668.
3. Multiply the principal by the variable interest rate for each month of the investment. For example, if the initial interest rate is 0.175 percent, but it drops to 0.15 percent, multiply $200,000 by 0.00175 to get $350, and multiply $200,000 by 0.0015 to get $300.
4. Add the variable returns together. Continuing the example, add $350 to $300 to get $650.
5. Subtract the total variable returns from the total fixed returns. With this example, subtract $650 from $668 to get $18. This is the value of the interest rate swap.
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