Swap Rate

A swap rate is a rate the receiver demands in exchange for the variable LIBOR or MIBOR rate after a specified period. Hence, it is the fixed leg of an interest rate swap, and such a 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 concerning a benchmark rate such as LIBOR. It can be either plus or a minus spread. Sometimes, it may be an exchange rate associated with the fixed portion of a currency swap.

• A swap rate is the fixed interest rate agreed upon by parties in an interest rate swap, exchanged for the variable LIBOR or MIBOR rate after a specified period. 
• In a forward contract, the swap rate represents the price at which one party agrees to exchange its market liquidity for the other's predetermined rate. This reference rate, often involving LIBOR, is utilized when trading a specified amount at an agreed-upon rate.
• For investors, the swap rate serves as a crucial benchmark for assessing the potential benefits of engaging in interest rate swaps.

The swap rate, in the field of investment and finance, refers to that part of the swap agreement in which the interest rate is fixed. When the derivative contract for interest rate swap is executed, the interest rate that is used for calculating the fixed part of payment is this swap rate.

The interest rate swap, as elaborated in the sections below, is a type of financial agreement in which two parties exchange cash flows of interest rates. This fixed rate in the above contract will not change throughout the entire duration of swap.

This swap rate interest is usually fixed by parties to the agreement at the beginning and is based on either the market forces of demand and supply or market expectation regarding future movements of interest rates. It may be influenced by many factors which include the credit risk, the liquidity level of the market, the current interest rates etc.

This rate is a widely used financial application. Quite often, various investors and big corporations enter into the swap rate in forex, currency or interest agreement where this kind of derivative contract acts as a hedge for the parties against interest fluctuations through the exchange of floating and fixed cash flows. The fixed-rate compensates for the risk of floating cash flow. Each type of swap rate has its features, usage, and purpose. They play an essential role in financial instrument valuation.

Swaps in finance are basically of three types:

#1 - Interest Rate Swap

Interest rate swap is where cash flows are exchanged at the fixed rate about the floating rate. It is an agreement between two parties in which they have decided to exchange a series of payments. In such a payment strategy, a fixed amount will be paid by one party, and another party will pay the floating amount at a certain period.

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 during a pre-specified trade interval.
• A Basis Swap – In the case of floating to floating swap, it is possible to exchange the floating legs based on benchmark rates.
• An Amortizing Swap – In the amortization swap, the notional amount decreases with the decrease in the amortization loan amount; respectively, the swap amount also decreases.
• Step-up Swap – The notional amount upsizes on the pre scheduled day in this swap.
• 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 and what they have agreed upon when the swap will come into effect, whether on delayed start Swaps, Deferred Swaps, or Forward Swaps.

#2 - Currency Swap

It is a swap rate in forex in which the cash flows of one currency are exchanged for another, which is almost similar to the interest swap.

#3 - Basis Swap

In this swap, the cash flow of both 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; both legs are floating legs in both cases.

Now let us try to understand the formula that is used to calculate swap rate.

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

C =

It represents that the fixed-rate interest swap, symbolized as a C, equals one minus the present value factor that applies to the last cash flow date of the swap divided by the summation of all the present value factors corresponding to all previous dates.

Concerning the change in time, in order to calculate swap rate, the fixed leg rate and floating leg rate change concerning the time that was initially locked. The new fixed rates corresponding to the new floating rates are termed the equilibrium swap rate.

The mathematical representation is as follows:

Where:

• N = Notional Amount
• f =  fixed rate
• c =  fixed rate negotiated and locked at the initiation
• PVF = Present value factors

Next, we try to understand the concept with the help of some suitable examples.

Example 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 where 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 the 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 in a 2% fixed rate on loan; the overall value of the swap would be  -129.88 million.

Thus, the above examples clearly explain the concept of daily swap rate in detail. It is important to understand that they are usually performed between large companies to meet the specific financing requirements that could be a beneficial arrangement to meet everyone's requirements. They could be an excellent means for a business to manage outstanding loans.  And the value behind them is the debt that can be either fixed or floating.

There are two reasons why companies want to engage in daily swap rate:

• Commercial Motivations: Few companies meet the businesses with specific financing requirements and interest swaps, which help managers attain the organization's pre-specified goals. Banks & Hedge Funds are the two most common types of businesses that benefit from 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.
• Diversify – The investors can take advantage of interest fluctuations and earn return using derivatives. This si an opportunity to diversify funds and gain exposure t different market segments.
• Customised – This concept offers customization of contracts and that is tailor made to meet needs related to payment frequency, selection of reference rates, etc.

Interest swaps are associated with huge risks, 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 a level of complicacy to the equation.
• If one party defaults, then the other has to bear the loss. To mitigate this parties sometimes has to resort to credit assessment or collateral agreements.
• Complex structure – The structure of the system is quite complex, that requires clear understanding of derivatives and intricacies and risks related to swaps, interest rates, market conditions, etc.
• Selection of rates – In case the floating rate is based on a benchmark that is different from the rate in the underlying asset, there will be risks related to gain of one party at the other’s cost.
• Regulatory changes – Any regulatory changes in the financial market related to accounting standards, rules, etc, will impact the cost and benefits of the swap rate interest.
• Impact of financial crisis – In case the market is very volatile or there is some economic or financial crisis, lack of liquidity, this will make the terms of entry and exit into such contracts very difficult.

Thus, the above are some advantages and disadvantages of the concept and they should be used after having a clear idea about its various components, risks, features, factors influencing them, implication of different cases in the earnings, etc.

The above are two important kinds of interest rates very commonly used in the financial market. But the purpose and features of both are different from each other. Let us study he differences.

• The former is the fixed part of interest rate that is used in the derivative contract called interest rate swap, but the latter is yield on fixed financial instruments or securities issued by the government of a country.
• The former is used in different types of derivative instruments like currency or interest rate swap, equity swap or commodity swap. But the latter is the interest rate of treasury bills, notes or bonds, which especially refer to the ones that are issued by US department of Treasury.
• The former is the fixed part of interest rate which acts as a compensation against fluctuation in the varablle part of the interest rate when the parties enter into a derivative contact of interest rate swap but the latter is a reference point thatis used for pricing different financial instruments like mortgages, company bonds, or any other securities related to fixed income.

• The former is affected by credit risk or market fluctuations but the latter has very low risk level due to its backing from the government of the country.

This has been a guide to what is Swap Rate. We explain it with examples, formula, differences with treasury rates, types, advantages & disadvantages. You may learn more about risk management from the following articles –

• What are Equity Swaps?
• Derivatives in Finance
• Commodity Derivatives