What Is a Forward Swap?
A forward swap, also called a deferred or delayed-start swap, is an agreement between two parties to exchange cash flows or assets on a fixed date in the future, and which also commences at some future date (specified in the swap agreement).
Interest rate swaps are the most common type of swap that uses a forward swap, although it could involve other financial instruments as well.
- Forward swaps, or deferred swaps, feature a delayed start to a swap agreement.
- Forward swaps occur most commonly with interest rate swaps, where interest payments are set to be exchanged beginning at a future date.
- Forward swaps allow financial institutions to hedge risk, engage in arbitrage, and exchange cash flows or liabilities.
Understanding Forward Swaps
A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments. A forward swap delays the start date of the obligations agreed to in a swap agreement made at some prior point in time.
Forward swaps can, theoretically, include multiple swaps. In other words, the two parties can agree to begin exchanging cash flows at a predetermined future date and then agree to another set of cash flow exchanges to begin at another date beyond the first, previously agreed-upon swap date. For example, if an investor wants to hedge for a five-year duration beginning one year from today, this investor can enter into both a one-year and six-year swap.
In the context of an interest rate swap, the exchange of interest payments will commence at a future date agreed to by the counterparties to this swap. In this swap, the effective date is some day in the future, but greater than the usual one or two business days that are typical of a swap. For example, the swap may take effect three months after the trade date.
Swaps are useful for investors seeking to a hedge their borrowing on the expectation that interest rates (or exchange rates) will change in the future. The delayed start of the forward swap contract removes the need to pay for the transaction today (hence the term "deferred start").
The calculation of the swap rate is similar to that for a standard swap (also called a vanilla swap).
Forward Swap Example
Company A has taken a loan for $100 million at a fixed interest rate; Company B has taken a loan for $100 million at a floating interest rate. Company A expects that interest rates six months from now will decline and therefore wants to convert its fixed rate into a floating one to reduce loan payments.
On the other hand, Company B believes that interest rates will increase six months in the future and wants to reduce its liabilities by converting to a fixed-rate loan. The key to the swap, aside from the change in the companies' views on interest rates, is that they both want to wait for the actual exchange of cash flows (six months in this case) while locking in right now the rate that will determine that cash flow amount.