In floating leg of IR swaps, there are 2 compouding methods.Could someone please answer the following for me.Many Thanks1.What is the definition of straight compounding, flat compounding in IR swaps?2. How much of a difference does it make between the methods?3. Why do we have two differrent methods?

really ? I did not know this

This wrinkle has to do with how to treat floating legs where the rate observation period is shorter than the accrual period. An example is a floating leg indexed to 3-month LIBOR but paid semi-annually. One has to decide what to do with the accreted value after 3 months when the second rate setting is observed.There are actually 3 methods that I'm aware of. I don't have any technical documentation at hand so I may not have the names right but in one method one simply adds without compounding the first 3-month's interest acccrual to the second 3-months interest accrual. That is likely called the flat method. Makes no sense, really, but there it is.There are two methods that compound the intermediate accruals but they differ in how any floating side spread is treated. In the compound with spread method (again, I'm not 100% sure of the name) you compound the accreted interest (including spread) after 3 months out another 3 months to the payment date using the then-observed second 3-month rate setting (again plus spread).Then there is a truly bizarre method (used at one time in Australia if memory serves me correct) that compounds the first period's accrual at the underlying rate index but without the spread.What I've called the compound with spread method obviously makes financial sense. The other two are bat-shite silly but so is assuming 360 days in a year, no?

Could you elaborate what the spread is?Is that the spread the cost of funding dealer charge?Please explain in detail to a newbie.Thanks,

I know this is an old topic, but let me know if people still need an answer to this topic.Basically in the market right now specific to IR derivatives and the like there are two forms of compounding supported.Flat and StraightThe difference is how the spread is handled in the compounding period.Flat CompoundingSpread is calculated off of Original NotionalInterest Portion is calculated off of Modified NotionalStraight CompoundingSpread and Interest are treated the same so total interest is calculated off of Modified Notional.