What Is a Forward Swap?
A forward swap, often called a deferred swap, is an agreement between two parties to exchange assets on a fixed date in the future. Interest rate swaps are the most common type of a forward swap, though it could involve other financial instruments as well. Other names for a forward swap are 'forward start swap' and 'delayed start swap.'
- Forward swaps, or deferred swaps, are agreements between two parties to exchange assets on a fixed future date.
- The most common type of forward swaps are interest rate swaps, where interest payments are exchanged 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 is a strategy that provides investors with the flexibility to meet investment goals. It offers financial institutions the ability to hedge risk, engage in arbitrage, and exchange cash flows or liabilities as required.
In 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 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).
Forward swaps can, theoretically, include multiple swaps. In other words, the two parties can agree to exchange cash flows at a predetermined future date and then agree to another set of cash flow exchanges for another date beyond the first 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, creating the forward swap that satisfies their portfolio's needs.
Forward Swap Example
Company A has taken a loan for $100 million at a fixed interest rate and 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.