Swap Rate Definition

The swap rate in a forward contract is the fixed-rate (fixed interest rate or fixed exchange rate) that one party agrees to pay to the other party in exchange for uncertainty related to the market. In an interest rate swap, a fixed amount is exchanged at a specific rate concerning a benchmark rate such as LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions.read more. It can be either plus or a minus spread. Sometimes, it may be an exchange rate associated with the fixed portion of a currency swap.

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Top 3 Types of Swap

Swaps in financeSwaps In FinanceSwaps in finance involve a contract between two or more parties that involves exchanging cash flows based on a predetermined notional principal amount, including interest rate swaps, the exchange of floating rate interest with a fixed rate of interest.read more are basically of three types:

#1 – Interest Rate Swap

Interest rate swapInterest Rate SwapAn interest rate swap is a deal between two parties on interest payments. The most common interest rate swap arrangement is when Party A agrees to make payments to Party B on a fixed interest rate, and Party B pays Party A on a floating interest rate.read more is where cash flows are exchanged at the fixed rate about the floating rate. It is an agreement between two parties in which they have decided to exchange a series of payments. In such a payment strategy, a fixed amount will be paid by one party, and another party will pay the floating amount at a certain period.

The notional amount is usually referred to decide the size of the swap; in the whole process of the contract, the notional amount remains intact. Examples of Interest Rate Swap Include

  • Overnight Index Swaps – Fixed v/s NSE overnight MIBOR Index andINBMK Swap – Fixed v/s 1-year INBMK rate

  • A Plain Vanilla Swap – In this type, a fixed rate is exchanged for a floating rate or vice versa during a pre-specified trade interval.A Basis Swap – In the case of floating to floating swap, it is possible to exchange the floating legs based on benchmark rates.An Amortizing Swap – In the amortization swap, the notional amount decreases with the decrease in the amortization loan amount; respectively, the swap amount also decreases.Step-up Swap – The notional amount upsizes on the pre scheduled day in this swap.Extendable Swap – When one of the counterparties has the right to extend the maturity of the trade. That swap is known as an extendable swap.Delayed Start Swaps/Deferred Swaps. Inward Swaps – It all depends upon the parties and what they have agreed upon when the swap will come into effect, whether on delayed start Swaps, Deferred Swaps, or Forward Swaps.

#2 – Currency Swap

It is a swap in which the cash flows of one currency are exchanged for another, which is almost similar to the interest swap.

#3 – Basis Swap

In this swap SwapSwaps in finance involve a contract between two or more parties that involves exchanging cash flows based on a predetermined notional principal amount, including interest rate swaps, the exchange of floating rate interest with a fixed rate of interest.read more, the cash flow of both legs refers to different floating rates. Some of the swaps majorly refer to fixed against floating legs like LIBOR. While in the basis swap, both the legs are floating rates. A basis swap can be either an interest swap or a currency swap; both legs are floating legs in both cases.

Formula to Calculate Swap Rate

The rate is applicable to the fixed payment leg of the swap. And we can use the following formula to calculate the swap rate.

C =

It represents that the fixed-rate interest swap, symbolized as a C, equals one minus the present value factor that applies to the last cash flow date of the swap divided by the summation of all the present value factors corresponding to all previous dates.

Concerning the change in time, fixed leg rate and floating leg rate change concerning the time that was initially locked. The new fixed rates corresponding to the new floating rates are termed the equilibrium swap rate.

The mathematical representation is as follows:

Where:

  • N = Notional Amountf =  fixed ratec =  fixed rate negotiated and locked at the initiationPVF = Present value factorsPresent Value FactorsPresent value factor is factor which is used to indicate the present value of cash to be received in future and is based on time value of money. This PV factor is a number which is always less than one and is calculated by one divided by one plus the rate of interest to the power, i.e. number of periods over which payments are to be made.read more

Examples of Swap Rate (Interest Rate)

Example 1

  • Six month USD LIBOR against three months USD LIBOR2. 6-month MIFOR against six-month USD LIBOR.

Example 2

If we consider an example where you negotiate a 2% pay fixed, in reverse, receive a floating swap at a variable rate to convert 5-years $200 million loans to a fixed loan. Evaluate the value of the swap after one year, given in the following floating rates present value factor schedule.

The calculation of the swap rate formula will be as follows,

F = 1 -0.93/(0.98+0.96+0.95+0.93)

The equilibrium fixed swap rate after one year is 1.83%

The calculation of the equilibrium swap rate formula will be as follows,

=$200 million x(1.83% -2%) * 3.82

Initially, we locked in a 2% fixed rate on loan; the overall value of the swap would be  -129.88 million.

Advantages

There are two reasons why companies want to engage in swaps:

  • Commercial Motivations: Few companies meet the businesses with specific financing requirements and interest swaps, which help managers attain the organization’s pre-specified goals. Banks & Hedge Funds are the two most common types of businesses that benefit from interest swaps are Banks & Hedge FundsHedge FundsA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques.read moreComparative Advantages: Most of the time, companies want to take advantage of either receiving a fixed or floating rate loan at an optimal rate than the other borrowers are offering. However, it is not financing; they are seeking a favorable opportunity of hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more in the market so they can make a better return out of it

Disadvantages

Interest swaps are associated with huge risks, which we have specified below:

  • Floating rates are variable rates due to this reason. It adds more risk to both parties.Counterparty riskCounterparty RiskCounterparty risk refers to the risk of potential expected losses for one counterparty as a result of another counterparty defaulting on or before the maturity of the derivative contract.read more is another risk that adds a level of complicacy to the equation.

Conclusion

They are usually performed between large companies to meet the specific financing requirements that could be a beneficial arrangement to meet everyone’s requirements. They could be a great means for a business to manage outstanding loans.  And the value behind them is the debt that can be either fixed or floating.

This has been a guide to what Swap Rate is and its definition. Here we discuss the types of swaps, examples, advantages, and disadvantages. You may learn more about risk management from the following articles –

  • What are Equity Swaps?Derivatives in FinanceCommodity Derivatives