Definition of forward swap
What is a forward swap?
A forward swap, also called a deferred or deferred swap, is an agreement between two parties to exchange cash flows or assets, but starting on a fixed date in the future.
Interest rate swaps are the most common type of swap that uses a delayed start, although it can involve other financial instruments as well.
Key points to remember
- Forward swaps, or deferred swaps, involve a delayed start of a swap agreement.
- Forward swaps most often occur with interest rate swaps, where interest payments are supposed to be exchanged at a later date.
- Forward swaps allow financial institutions to hedge risk, engage in arbitrage, and trade cash flows or liabilities, but they don’t need to be effective immediately.
Understanding Forward Swaps
A swap is a derivative contract where two parties exchange the cash flows or liabilities of two different financial instruments. A forward swap simply delays the start date of obligations agreed to in a swap agreement entered into at an earlier time.
In an interest rate swap, the exchange of interest payments will begin on a future date agreed to by the counterparties to that swap. In this swap, the effective date is defined as being beyond the usual business day (s) after the trade date. For example, the swap can take effect three months after the trade date. It is useful for investors looking to secure a hedge, or cost of borrowing, today with the expectation that interest rates or exchange rates will change in the future. However, this removes the need to start the transaction today, hence the term “delayed start” or “delayed start”. The calculation of the swap rate is similar to that of a standard swap (also called a vanilla swap).
In theory, forward swaps can include multiple swaps. In other words, both parties can agree to start trading cash flow on a predetermined future date and then agree to another set of cash flow trading to start on another date beyond the date. first swap date. For example, if an investor wishes to hedge for a period of five years from one year from today, that investor can enter into a one-year and six-year swap, thus creating the forward swap which meets the needs of its portfolio.
Example of a forward swap
Company A took out a loan of $ 100 million at a fixed rate of interest and Company B took out a loan of $ 100 million at a variable rate of interest. Company A expects interest rates to drop in six months and therefore wants to convert its fixed rate to a floating rate to reduce loan repayments. On the other hand, Company B estimates that interest rates will rise six months into the future and wants to reduce its liabilities by converting to a fixed rate loan. The key to the swap, aside from the companies changing perspective on interest rates, is that they both want to wait for the actual exchange of cash flows (six months in this case) while now locking in the rate that will determine this amount of cash flow.