Forward Swap

Forward Swap
See also
Interest rate differential Interest rate swaps Cash bond Alternative futures Life Cap Trading Book Options Sinkable bond Vomma

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).

Examples of Forward Swap

• Forward Interest Rate Swap: This type of forward swap is used to exchange fixed rate interest payments for floating interest rate payments between two counterparties. The fixed rate payments are determined at the start of the contract, while the floating rate payments are based on a pre-determined reference rate such as LIBOR.
• Forward Currency Swap: This type of forward swap is used to exchange payments in one currency for payments in another currency. The payments are exchanged at a predetermined rate, and the two counterparties agree to swap the payments over a certain period of time.
• Forward Equity Swap: This type of forward swap is used to exchange cash flows linked to the performance of a particular equity index or stock. The payments are exchanged at a predetermined rate, and the two counterparties agree to swap the payments over a certain period of time.

Other approaches related to Forward Swap

One of the other approaches related to forward swap is the use of derivatives, such as futures and options, to hedge against market risk. *Futures are contracts that oblige both parties to exchange an asset at a predetermined price at a specified date in the future. *Options are contracts that give the buyer the right to buy or sell an asset at a predetermined price, but not the obligation to do so. *Swaptions are options to enter into a swap agreement, giving the buyer the right, but not the obligation, to enter into an interest rate swap at a predetermined rate. *Caps and floors are agreements that limit the exposure of one party to changes in market interest rates, by setting a maximum or minimum interest rate that the party is willing to pay.

In summary, derivatives such as futures, options, swaptions, caps and floors can all be used in combination with forward swaps to hedge against market risk.

References

• Bhalla V.K. (2014).,International Financial Management (Text and Cases), S. Chand Publishing, New Delhi
• 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