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 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.. 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 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. 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. 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., 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.
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:
- N = Notional Amount
- f = fixed rate
- c = fixed rate negotiated and locked at the initiation
- PVF = 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.
Examples of Swap Rate (Interest Rate)
- Six month USD LIBOR against three months USD LIBOR
- 6-month MIFOR against six month USD LIBOR.
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,
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 up in 2% fixed rate on 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 that engage in to meet the businesses with specific financing requirements, and interest swaps, which help managers to attain pre-specified goals of the organization. The two most common types of businesses that get benefited from the 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.
- 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 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. 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 to both parties.
- Counterparty risk is another risk that adds an additional level of complicacy to the equation.
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.
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 –