are portfolios of options on interest rates. The most prevalent swap contract is an interest rate swap. An interest rate swap contract provides a vehicle for market participants to transform the nature of cash flows and the interest rate exposure of a portfolio or balance sheet. In this chapter, we explain how to analyze interest rate swaps. We will describe a generic interest rate swap, the parties to a swap, the risk and return of a swap, and the economic interpretation of a swap. Then we look at how to compute the floating-rate payments and calculate the present value of these payments. Next we will see how to calculate the fixed-rate payments given the swap rate. Before we look at how to calcu- late the value of a swap, we will see how to calculate the swap rate. Given the swap rate, we will then see how the value of a swap is determined after the inception of a swap. We will also discuss other types of swaps, options on swaps called swaptions, and swap futures contracts. The final section of the chapter introduces caps and floors.       DESCRIPTION OF AN INTEREST RATE SWAP   In an interest rate swap, two parties (called counterparties) agree to exchange periodic interest payments. The dollar amount of the interest payments exchanged is based on some predetermined dollar principal,   229     which is called the notional amount. The dollar amount each counter- party pays to the other is the agreed-upon periodic interest rate times the notional amount. The only dollars that are exchanged between the parties are the interest payments, not the notional amount. Accordingly, the notional principal serves only as a scale factor to translate an interest rate into a cash flow. In the most common type of swap, one party agrees to pay the other party fixed interest payments at designated dates for the life of the contract. This party is referred to as the fixed-rate payer. The other party, who agrees to make interest rate payments that float with some ref- erence rate, is referred to as the floating-rate payer. The reference rates that have been used for the floating rate in an interest rate swap are various money market rates: Treasury bill rate, the London interbank offered rate, commercial paper rate, bankers acceptan- ces rate, certificates of deposit rate, the federal funds rate, and the prime rate. The most common is the London interbank offered rate (LIBOR). LIBOR is the rate at which prime banks offer to pay on Eurodollar depos- its available to other prime banks for a given maturity. There is not just one rate but a rate for different maturities. For example, there is a 1-