In this example, we will demonstrate the pricing of a plain vanilla IRS. The full details of the contract, including the choice of the mathematical model and its numerical method, are shown in the following Bento Box template:
Our aim here is to calculate the net present value of this IRS, in particular a paying fixed-for-floating IRS. In this contract, the holder pays the fixed rate and receives the floating rate at regular intervals.
We proceed by completing the contents of the Bento Box in clockwise sense, starting from the top-left corner. First, we will fill all the data of the contract, in particular the payoff function, which in our case is as follows:
The present value of the IRS is the sum of the discounted future payments of the IRS. Being a paying IRS, we pay the fixed rate K and we receive the future floating rate L. This rate is fixed (that is, determined) at the beginning of the period...