What is a Delayed Rate Setting Swap?
A delayed rate setting swap is an exchange of cash flows, one of which is based on a fixed interest rate and one of which is based on a floating interest rate, in which the spread (difference) between the fixed and floating interest rates is determined when the swap is initiated but the actual interest rates are not determined until later. The swap contract will designate the date on which the rates are determined and also the length of the contract at the specified rates.
A delayed rate setting swap may also be referred to as a “deferred rate setting swap” or a “forward swap.”
The Basics Of Delayed Rate Setting Swap
A delayed rate setting swap focuses on the spread that the parties in the agreement can expect. The spread is typically based on a benchmark interest rate which provides a proxy for the parties involved.
For instance, the spread on such a swap may be determined to be 100 basis points (or 1%) at initiation. A few days after the swap has been entered in to, the counterparties may subsequently define the floating interest rate as LIBOR + 1%.
Overview Of Interest Rate Swaps
Interest rate swaps are financial contract agreements that are exchanged between institutional investors. Swaps can be listed on institutional trading exchanges or negotiated directly between two parties.
Interest rate swaps are a risk management tool that allow institutions to swap fixed rate obligations for floating rate cash flows or vice versa. In a standard interest rate swap the two sides of the transaction will typically involve a floating rate and a fixed rate. By using these two positions both parties have the opportunity to speculate on their view of the interest rate environment. The fixed rate counterpart agrees to pay a fixed rate of interest on a specified amount for the benefit of receiving a floating rate.
The fixed rate counterpart generally believes that the outlook for rates is increasing and thereby seeks to lock in a fixed rate payout in receipt for a potentially rising floating rate that will create profit from the cash flow differential.
A floating rate counterpart takes the opposite view and believes that rates will be falling. If interest rates fall they have the advantage of paying a lower rate of interest that may fall below the fixed rate, with the cash flow differential in their favor.
Delayed Rate Setting Swap Consideration
A delayed rate swap can be beneficial when a counterparty finds the offered spread favorable to market conditions. For example, two counterparties may agree to fixed and floating rate terms based on the one-year Treasury plus 50 basis points. In this scenario the spread differential between the fixed and floating rates would be zero and the actual base rate would be set when the swap begins sometime in the future. The fixed rate payer believes this rate will be favorable at the time the contract commences. They also believe that rates will be rising with the floating rate cash flows providing a profit. As is typical for swap positions, the floating rate counterparty believes rates will fall in their favor.
Generally most delayed rate setting swaps will begin shortly after the spread terms have been agreed on. Once the actual swap interest rates have been set, a delayed rate setting swap acts like a regular interest rate swap. A delayed rate setting swap adds an additional element of risk since both parties have contracted for a rate that will be set at a time in the future.