The forward swap are transactions which are concluded simultaneously, but they have different maturities (V.K. Bhalla 2002, s.487) . The buyer and seller of the forward swap are required to set a future date on which they both agree, duration and the fixed coupon coupon rate of the contract. Both parties that participate in the transaction, use the contract concluded between them to lock in the future swap rate. At the beginning, the contract is valued at zero, but it's value will change on condition if the market interest rates change. A forward swap can be also traded (what happens often ) on the counter market (Y. Tang, B. Li 2007, s.395).
Applying of forward swap
In many cases forward swaps are like other derivatives (futures), but on securities which are debt, because often they are used like a futures for example:
- blocking future interest rates
- changes in the balance sheet exposure to changes in the interest rate
But on the other hand, there are many factors that separate them from futures, because they can be tailored to specific investment or loan need and they can also be used in long-term positions (R. Stafford Johnson 2013, s. 641).
Forward swap valuation
In the case of forward swap, a fee may be charged in advance. The value of the forward swap depends on several factors. It is important whether the interest rate of the underlying forward swap differs from the forward swap threshold (R. Stafford Johnson 2013, s. 641). The value of the forward swap can be also shown proportional to the difference between the current swap rate and the fixed swap rate (Yue-Kuen Kwok 1998, s.442)
Forward swap rate
The forward swap rate is called the interest rate on the fixed side of the swap transaction that has a current value (at time t) of zero. The forward swap frequency coincides with the swap speed as t -> T. As with the current value, the forward swap rate at t <T, does not depend directly on time T. The forward swap rate remains the same, as long as the respective future fixing and payment dates remain unchanged (H. Deutsch 1999, s.317). We can also observe that long-term forward swap rates are positively correlated with short-term LIBOR forward contracts. That happens in the USD swap market (H. Corb, s.579).
Disadvantages of swap transactions
The biggest disadvantage of swap transactions is that they do not provide complete protection against exchange risk. The first problem associated with this type of transaction is that there may be a change in premium or rebate between the date of the original contract and the date of the adjustment, which is unfavorable. The second problem with swap transactions is that the collapse of the forward market can block the company from making an adjustment swap (V.K. Bhalla 2002, s.487).
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- Corb H. (2012)., Interest Rate Swaps and Other Derivatives, Columbia University Press, New York
- Deutsch H.(2003)., Derivatives and Internal Models, Springer, New York
- Johnson Stafford R. (2013)., Debt Markets and Analysis, John Wiley & Sons, Hoboken
- Kwok Yue-Kuen (2008)., Mathematical Models of Financial Derivatives, Springer Science & Business Media, Berlin
- Tang Y., Li B. (2007).,Quantitative Analysis, Derivatives Modeling, and Trading Strategies: In the presence of counterparty credit risk for the fixed-income marekt, World Scientific, Toh Tuck Link
Author: Anna Jędrzejczyk