A swap is a contract between two parties to exchange payments based on some underlying assets, such as interest rates, currencies, or commodities. For example, one party may agree to pay a fixed interest rate on a loan, while the other party pays a variable interest rate on the same loan. This way, they can hedge their risks or benefit from the market movements.
Reversing a swap transaction means entering into another swap contract that has the opposite terms of the original swap. For example, if the original swap was a fixed-for-floating interest rate swap, the reverse swap would be a floating-for-fixed interest rate swap. By doing this, the parties can cancel out their obligations under the original swap and end their exposure to the underlying assets.
Reversing a swap transaction can be done for various reasons, such as:
- To lock in a profit or avoid a loss from the original swap.
- To change the duration or the risk profile of the original swap.
- To exit the original swap before its maturity date.
Reversing a swap transaction can be done either with the same counterparty or with a different counterparty. If it is done with the same counterparty, the parties can simply agree to terminate the original swap and settle any net payments. If it is done with a different counterparty, the parties need to find a matching swap in the market and enter into a new contract.
Basic Theory
Swaps typically involve an exchange of future cash flows based on predetermined terms. To reverse a swap, we need to understand the concept of the present value of future cash flows. The present value represents the current worth of future cash flows, discounted at an appropriate rate.
Procedures
- Identify Swap Terms:
- Determine the remaining cash flows of the swap, including notional amounts, interest rates, and payment dates.
- Calculate Present Value:
- Use the present value formula to calculate the current worth of future cash flows.Formula:
- Use the present value formula to calculate the current worth of future cash flows.Formula:
- Reverse Cash Flows:
- Multiply each cash flow by -1 to reverse the direction of the cash flows.
- Update Swap Positions:
- Adjust the positions of the parties involved by exchanging the reversed cash flows.
Scenario: Interest Rate Swap Reversal
Let’s consider a scenario with the following terms:
- Notional Amount: $1,000,000
- Fixed Interest Rate: 5%
- Floating Interest Rate (LIBOR): 3%
- Remaining Period: 2 years
Calculation in Excel
| Period | Fixed Cash Flow | Floating Cash Flow | Present Value (PV) |
|---|---|---|---|
| 1 | $50,000 | $30,000 | =PV(5%,1,0,(-30000)) |
| 2 | $50,000 | $30,000 | =PV(5%,2,0,(-30000)) |
Calculate Present Value:
In cell E2, enter the formula: =PV(5%,1,0,(-30000)) + PV(5%,2,0,(-30000))
Repeat the process for the fixed cash flows.
Reverse Cash Flows:
In cell D2, enter the formula: =-C2
Repeat the process for the fixed cash flows.
Update Swap Positions:
The reversed cash flows represent the amounts to be exchanged to reverse the swap transaction.
Result
The present value of the reversed cash flows will determine the amount to be exchanged between the parties to reverse the swap. In this scenario, it represents the fair value of the remaining swap contract.
Other Approaches
- Use Excel Solver:
- Set up a Solver model to find the discount rate that makes the present value of cash flows equal to zero. This provides an alternative method for determining fair value.
- Consider Market Data:
- Incorporate current market data, such as updated interest rates, to adjust the present value calculation based on real-time information.
