What Is a Floating Price?
In a swap contract, the floating price is the leg that depends on the level of a variable, such as an interest rate, currency exchange rate or price of an asset. Most swaps involve a floating and a fixed leg although it is possible for both legs to be floating.
The party paying the floating rate expects that rate to decline over the life of the swap.
Understanding Floating Price
A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time of contract initiation, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price.
However, the most common and most basic type of swaps is the plain vanilla interest rate swap, followed by the second most common, the currency swap.
In a plain vanilla interest rate swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period.
Plain Vanilla Swap
In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the times between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties.
While the fixed-rate stream does not change for the duration of the swap, the floating rate stream changes periodically. The floating rate will adjust as its benchmark interest rate, changes in accordance with market conditions. The benchmark is often LIBOR, but may also be the yield on one-year U.S. Treasury note or another interest rate.
Two parties, called counterparties, enter into fixed-for-floating swap transactions to reduce their exposure to changes in interest rates or to attempt to profit from changes in interest rates.
In a currency swap, the two counterparties exchange principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and end of the swap. The two specified principal amounts are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated.
Here, the floating price is the exchange rate between the two currencies.