I am ignorant/stupid. But this sunday afternoon I have seen the light! Thank ya jesus, thank ya lord.
A swap contract is not meant to create an NPV zero exchange throughout the life of the SWAP (otherwise why would anyone ever enter into a swap). It's guided by the principle of expected return, not no-arbitrage spreads. The only time no-arbitrage spreads come into play is the initial pricing of the swap contract, which is determined by the value of a floating rate bond (initially worth par), and the fixed rate set to make the stream of payments worth par, otherwise, the long swap position would profit risklessly 6-months from now with a coupon determined completely above par. The fixed rate paid must equal a coupon rate that makes the stream of payments worth par using rates determined by the yield curve today... and that's actualy determined by ZERO rates, NOT implied forwards.
Movements in the rates are free to go where they please, and the swap contract is not worth zero anymore after time progresses and rates shift. What was I thinking? Swap contracts worth an initial NPV zero and not no-arbitrage zero... HA!
That's alot of "X"es on my Problem Set #3 :(
Debt instruments kicks my ass.