What is a Swap Rate
A swap rate is the rate of the fixed leg of a swap as determined by its particular market and the parties involved. In an interest rate swap, it is the fixed interest rate exchanged for a benchmark rate such as LIBOR plus or minus a spread. It is also the exchange rate associated with the fixed portion of a currency swap.
Breaking Down the Swap Rate
Swap rates are applied to different types of swaps. An interest rate swap is the exchange of a floating interest rate for a fixed interest rate. A currency swap is the exchange of interest payments in one currency for those in another. In both types of transaction, the fixed element is referred to as the swap rate.
Interest Rate Swap
In an interest rate swap, one party will be the payer and the other will be the receiver of the fixed rate. The cash flow of the fixed rate leg of the swap is set when the trade is undertaken. The cash flow for the floating rate leg is set periodically on the rate reset dates, which are determined by the reset period of the floating rate leg.
The most common index for the floating rate leg is the three-month U.S. dollar LIBOR. This can either be paid quarterly or compounded and paid semi-annually. The rate above or below LIBOR reflects the yield curve and the credit spread to be charged.
Interest rate payments between the fixed and the floating rate legs are netted at the end of each payment period, and only the difference is exchanged.
There are three different types of interest rate exchanges for a currency swap: (1) the fixed rate of one currency for the fixed rate of the second; (2) the fixed rate of one currency for the floating rate of the second; and (3) the floating rate of one currency for the floating rate of the second.
The swap can include or exclude a full exchange of the principal amount of currency at both the beginning and the end of the swap.
The interest rate payments are not netted because they are calculated and paid in different currencies.
Regardless of whether the principal is exchanged, a swap rate for the conversion of the principal must be set. If there is no exchange of principal, then the swap rate is simply used for the calculation of the two notional principal currency amounts on which the interest rate payments are based. If there is an exchange, where the swap rate is set can have a large profit or loss impact on the parties since the exchange rate could change drastically between the start of the agreement and its conclusion.