Understanding and Calculating Forward Swaps Exchange Rates in Excel

A forward swap is a type of swap agreement that starts at a future date, rather than the usual one or two business days after the trade date. A swap is a contract in which two parties agree to exchange cash flows or assets based on different financial instruments, such as interest rates, currencies, or commodities.

The purpose of a forward swap is to lock in the current swap rate for a future transaction, without paying for it today. This can be useful for hedging or speculating on the future movements of interest rates, exchange rates, or commodity prices. For example, a company that expects to borrow money at a floating interest rate in six months may enter into a forward swap to convert its future payments to a fixed rate, based on the current swap rate. Alternatively, an investor who anticipates a decline in interest rates may enter into a forward swap to receive a fixed rate and pay a floating rate, hoping to profit from the difference.

The calculation of the swap rate for a forward swap is similar to that for a standard swap, except that it takes into account the time value of money and the expected changes in the underlying variables. The swap rate is the fixed rate that makes the present value of the fixed payments equal to the present value of the floating payments, based on the current market rates and expectations. The swap rate can be derived from the zero-coupon yield curve, which shows the relationship between the interest rates and the maturities of risk-free bonds.

A forward swap can be seen as a combination of two swaps: a spot swap that starts today and ends at the forward date, and a forward-forward swap that starts and ends at the same dates as the original forward swap. The net effect of these two swaps is to cancel out the payments until the forward date, and then resume the payments as agreed in the forward swap. This way, the parties can avoid paying or receiving any cash flows until the forward date, while still locking in the swap rate today.

Basic Theory:

A forward swap is a financial agreement between two parties to exchange a set amount of currencies at a future date,
at a predetermined exchange rate. This helps participants hedge against currency fluctuations and manage their
exposure in the foreign exchange market.

The forward swap rate is determined by the interest rate differentials between the two currencies involved. It reflects
the cost or benefit of entering into the swap agreement.

Procedures:

1. Identify Currencies and Terms:
   • Determine the currencies involved in the swap.
   • Specify the terms, including the notional amount, maturity date, and the forward swap rate.
2. Calculate Interest Rate Differentials:
   • Find the interest rates for each currency.
   • Calculate the interest rate differential by subtracting the interest rate of the currency being bought from
     the one being sold.
3. Calculate Forward Swap Rate:
   • Use the interest rate differentials to calculate the forward swap rate using the formula:
     

        

     Where and are the domestic and foreign interest rates, and
     is the number of compounding periods per year.

Comprehensive Example:

Let’s consider a scenario where a U.S. company plans to exchange $1,000,000 for euros in six months. The current
spot rate is 1 USD = 0.85 EUR. The U.S. interest rate is 2%, and the Eurozone interest rate is 1.5%, compounded
semi-annually.

Excel Calculation:

1. Create an Excel table:
   

   Description	Data
   Spot Rate	0.85
   U.S. Interest Rate	0.02
   Eurozone Interest Rate	0.015
   Compounding Periods	2

2. Calculate Forward Swap Rate:

   In Excel, use the formula:

      

   Result: Forward Swap Rate = 0.849207 (rounded to 6 decimal places)

3. Calculate Forward Swap Amount:

   Given the notional amount of $1,000,000, the forward swap amount in euros is:

      

   Result: Forward Swap Amount = $849,207 (rounded)