What is a Forward Swap
A forward swap is an agreement between two parties to swap assets, interest rates, currencies, or other instruments on a set date in the future with predefined terms. It is a strategy used to provide investors with the flexibility to meet investment goals. For example, one party may wish to hedge their risk, match cash flows, or engage in arbitrage but is willing to accept the risk for the initial term of an investment. Interest rate swaps are the most common example of forward swaps.
They are also called a "forward start swap," "delayed start swap," and a "deferred start swap."
Forward swaps can also be a combination of two swaps differing in duration for the purpose of fulfilling the specific time-frame needs of an investor.
BREAKING DOWN Forward Swap
In this swap the effective date is defined to be beyond the usual one or two business days after the trade date. For example, the swap may take effect three months after the trade date. It is useful for investors seeking to fix a hedge, or cost of borrowing, today on the expectation that interest rates or exchange rates will change in the future. However, it removes the need to start the transaction today, hence the term "delayed start" or "deferred start." The calculation of the swap rate is similar to that for a standard swap (vanilla swap).
Example of a Forward Swap
For example, company A takes a loan for $400 million at a fixed interest rate and company B takes a loan for $400 million at a floating interest rate. Company A expects the rate six months in the future will decline and therefore wants to convert its fixed rate into a floating one. But because the rate changes are not expected to happen right away, the company just wants to lock in the swap rate for later. On the other hand, company B believes that interest rates will increase six months in the future. It does not want to convert into a fixed rate loan right away but wants to protect itself by locking in the rate now. The companies may enter into an interest rate swap to hedge their risk.
A forward swap can consist of more than one swap: for example, the counterparties can agree to swap interest rates beginning in six months, and then to swap different interest rates a year after that. 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, creating the forward swap that meets the needs of his or her portfolio.