Swap Rate

Swap Rate Definition

A swap rate is a rate, the receiver demands in exchange for the variable LIBOR or MIBOR rate after a specified period and hence it is the fixed leg of an interest rate swap and such rate gives the receiver base for considering profit or loss from a swap.

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 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.

Swap Rate

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For eg:
Source: Swap Rate (wallstreetmojo.com)

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 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 the case of floating to floating swap, it is possible to exchange the floating legs on the basis of benchmark rates.
  • An Amortizing Swap – In the 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. Inward 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 the 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 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 the 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 in both the cases, both legs are floating legs.

Formula to Calculate Swap Rate

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

C =Swap rate formula

It represents that the fixed-rate interest swap, which is symbolized as a C, equals one 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 factors 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:

Swap rate formula1

Where:

Examples of Swap Rate (Interest Rate)

Example 1

  1. Six month USD LIBOR against three months USD LIBOR
  2. 6-month MIFOR against six month USD LIBOR.

Example 2

If we consider an example in which 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 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,

formula example 1

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,

example 2

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

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

Advantages

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

Disadvantages

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 to both parties.
  • Counterparty risk is another risk that adds an additional level of complicacy to the equation.

Conclusion

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 rate. They are usually performed between large companies to meet the specific financing requirements that could be a beneficial arrangement to meet everyone’s requirements.

Recommended Articles

This has been a guide to what Swap Rate is 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 –

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Comments

  1. VIVEK ROYZADA says

    Very useful formula to compute SWAP RATE and Value of swap.

    • Dheeraj Vaidya says

      Thanks for your kind words!

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