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- Certificate in Quantitative Finance (CQF) Exam Guide
- Relative Risk Reduction Formula
Swap Rate Definition
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 of uncertainty related to the market. In an interest rate swap, a fixed amount is exchanged at a specific rate with respect to a benchmark rate such as LIBOR. It can be either plus or minus of spread. Sometimes, it may be an exchange rate associated with the fixed portion of a currency swap.
Top 3 Types of Swap
Swaps are basically of three types:
#1 – Interest Rate Swap
Interest rate swap is where cash flows are exchanged at the fixed rate in reference to the floating rate. It is an agreement between two parties in which they have decided to exchange a series of payment between them. In such a payment strategy, a fixed amount will be paid by the one party and the floating amount will be paid by another party at a certain period of time.
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 and
- INBMK Swap – Fixed v/s 1-year INBMK rate
Types of Interest Rate Swaps
- A Plain Vanilla Swap – In this type, a fixed rate is exchanged for a floating rate or vice versa on a pre-specified interval during the course of the trade.
- A Basis Swap – In case of floating to floating swap, it is possible to exchange the floating legs on the basis of benchmark rates.
- An Amortizing Swap – In amortization swap, the notional amount decreases with the decrease in the amortization loan amount, respectively swap amount also decreases.
- Step-up Swap – In this swap, the notional amount upsizes on the prescheduled day
- 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/ Forward Swaps – It all depends upon the parties, what they have agreed upon when the swap will come into effect whether on delayed start Swaps or Deferred Swap or Forward Swap.
#2 – Currency Swap
It is a swap in which cash flows of one currency are exchanged for the cash flow of another currency which is almost similar to the interest swap.
#3 – Basis Swap
In this swap, the cash flow of both the legs refers to different floating rates. Some of the swaps majorly refer to fixed against floating leg 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 in both the cases both legs are floating legs.
Formula to Calculate Swap Rate
It is the rate which is applicable to the fixed payment leg of the swap. And we can use the following formula to calculate the swap rate.
It represents that the fixed rate interest swap which is symbolized as a C equals 1 minus the present value factor that is applicable to the last cash flow date of the swap divided by the summation of all the present value factor corresponding to all previous dates.
With respect to change in time, fixed leg rate and floating leg rate changes with respect to time that was initially locked. The new fixed rates corresponding to the new floating rates is termed as the equilibrium swap rate.
The mathematical representation as follows:
- N = Notional Amount
- f = fixed rate
- c = fixed rate negotiated and locked at the initiation
- PVF = Present value factors
Examples of Swap Rate (Interest Rate)
- 6 month USD LIBOR against 3 months USD LIBOR
- 6-month MIFOR against 6 month USD LIBOR.
If we consider an example in which you negotiate a 2% pay fixed, in reverse receive floating swap at a variable rate to convert 5-years $200 million loans to a fixed loan. Evaluate the value of swap after 1 year, given in the following floating rates present value factor schedule.
The calculation of 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 1 year is 1.83%
The calculation of equilibrium swap rate formula will be as follows,
=$200million x(1.83% -2%) * 3.82
Initially, we locked up in 2% fixed rate on the loan, the overall value of the swap would be -129.88 million.
There are basically two reasons why companies want to engage in swaps:
- Commercial Motivations: There are few companies who engage in to meet the businesses with specific financing requirements, and interest swaps which helps managers to attain pre-specified goals of the organization. Two most common types of businesses that get benefited from the interest swaps are Banks & Hedge Funds
- Comparative 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 hedging in the market so they can make a better return out of it
Interest swaps are associated with huge risk which we have specified below:
- Floating rates are variable rates due to this reason it adds more risk for both the parties.
- Counterparty risk is another risk which adds an additional level of complicacy to the equation.
They could be a great mean for a business to manage outstanding loans. And the value behind them is the debt that can be either fixed or floating rate. They are usually performed between large companies to meet the specific financing requirements that could be a beneficial arrangement to meet everyone’s requirement.
This has been a guide to what is Swap Rate and its definition. Here we discuss the types of swaps along with examples, advantages and disadvantages. You may learn more about risk management from the following articles –