In going through the derivatives section- I am noticing that when discounting the hypothetical cash flows of say- the bond side of a swap- that sometimes the cash flows are discounted 1 way and sometimes another way- here is an example:
To value a fixed for floating swap- we set up the timeline to show the fixed bond’s cash flows. Assuming the cash flow is 10K in this example, sometimes I see this cash flow discounted as such:
10,000 / (1+RFR)^.5
And sometimes I see it discounted as
10,000 / (1+RFR * 180/360))
What is the difference between these 2 methods? Which should be used for normal cash flow discounting and which should be used to discount a swap’s cash flows?
Thanks!
Second is usually used for LIBOR as on add-on basis. First is more precise. Anyway, on amount of 10.000 cash units, the difference is not material.
More accurately, in the first method the discount rate is given as an effective annual rate, whereas in the second method the discount rate is given as a nominal annual rate (compounded semiannually).
While it’s true that LIBOR is quoted as a nominal rate, other rates are as well; furthermore, both quoted rates (the effective rate and the nominal rate) are add-on rates.
I wrote an article on nominal vs. effective rates: http://financialexamhelp123.com/nominal-vs-effective-interest-rates/.
(Full disclosure: as of 4/25/16 there is a charge to read the articles on my website. You can get an idea of the quality of the articles by looking at the free samples here: http://www.financialexamhelp123.com/sample-articles/.)
S2000, Thanks for additional explanation.
ahh- ‘More accurately, in the first method the discount rate is given as an effective annual rate, whereas in the second method the discount rate is given as a nominal annual rate (compounded semiannually’
this was super helpful I had forgotten it thanks!