A forward-start swap is a type of swap agreement that begins at a future date, rather than immediately. A swap is a contract between two parties to exchange cash flows or assets based on certain conditions. For example, an interest rate swap is a swap where one party pays a fixed interest rate and receives a floating interest rate, and vice versa.
A forward-start swap can be useful for hedging future interest rate risk, or for taking advantage of expected changes in market conditions. For instance, a borrower who expects interest rates to fall in the future may enter into a forward-start swap to lock in a lower fixed rate for a loan that will start later. Conversely, a borrower who expects interest rates to rise in the future may enter into a forward-start swap to secure a higher floating rate for a loan that will start later.
A forward-start swap is similar to a regular swap, except that the interest accruals and payments do not start until a specified date in the future. The fixed rate of the swap is determined at the time of the agreement, based on the current market rates and the forward premiums or discounts. A forward premium is the amount by which the forward rate exceeds the spot rate, and a forward discount is the amount by which the spot rate exceeds the forward rate. The forward rate is the expected future rate of an asset or a currency.
A forward-start swap can be seen as a combination of two swaps: a spot-starting swap and a forward-ending swap. A spot-starting swap is a swap that begins immediately, and a forward-ending swap is a swap that ends at a future date. The net effect of a forward-start swap is to cancel out the spot-starting swap and keep the forward-ending swap. For example, if a borrower wants to hedge a five-year loan that will start one year from now, they can enter into a one-year swap and a six-year swap. The one-year swap will offset the first year of the six-year swap, leaving a five-year swap that will start one year from now. This is equivalent to a forward-start swap that will start one year from now and last for five years.
Basic Theory:
An interest rate swap involves the exchange of cash flows between two parties based on interest rate movements. In a forward-start swap, the agreement is made today, but the swap only becomes effective at a future date. This allows parties to plan for changes in interest rates without immediate exposure.
Procedures:
- Agreement Date: Parties agree on the terms of the swap, including the notional amount, fixed and floating rates, and the forward-start date.
- Forward-Start Date: The effective date of the swap, which is in the future. On this date, the fixed and floating rate payments commence.
- Calculation Periods: Determine the calculation periods for the floating rate payments. These are typically set based on market conventions.
- Payment Frequency: Specify how often payments will be made, usually semi-annually.
Scenario:
Let’s consider a scenario where Company A and Company B enter into a forward-start swap. Company A pays a fixed rate of 4% and receives a floating rate based on LIBOR+1%. The notional amount is $10 million, and the forward-start date is in 6 months. The swap has a maturity of 2 years, with semi-annual payments.
Excel Calculation:
- Set up an Excel table with the following columns: Period, Start Date, End Date, Days, Fixed Rate, Floating Rate, Notional, Fixed Payment, Floating Payment, Net Payment.
- Populate the table with the relevant details for each period. The fixed rate remains constant, and the floating rate is based on the LIBOR rate at the start of each period.
- Use Excel formulas to calculate the fixed payment, floating payment, and net payment for each period.
- Sum the net payments to determine the overall cash flow for each party.
Excel Formulas:
Assuming the table starts at cell A1, the formulas in the Fixed Payment column (column H) would be:
=IF(B2>=Forward_Start_Date, Fixed_Rate*Notional*(Days/360), 0)
The Floating Payment column (column I):
=IF(B2>=Forward_Start_Date, (LIBOR_Rate+1%)*Notional*(Days/360), 0)
The Net Payment column (column J):
=I2-H2
Finally, calculate the overall cash flow for each party.
Results:
After inputting the relevant details and using the provided Excel formulas, you will obtain the cash flow for both parties over the swap period.
Alternative Approaches:
- Pricing Models: Implement advanced financial models, such as Black-Scholes or Binomial models, to calculate the forward-start swap value.
- VBA (Visual Basic for Applications): Automate the calculations using VBA for increased efficiency and flexibility.
