An interest rate swap is a contract between two parties to exchange fixed and floating interest payments on a notional principal amount. The swap is usually entered into for a specified period of time, such as one year, five years, or ten years. However, sometimes the parties may want to terminate the swap before its maturity date. This is called closing out an interest rate swap position.
There are different ways to close out an interest rate swap position, depending on the situation and the preferences of the parties. Here are some common methods:
- Wait for the end of the contract. This is the simplest way to close out an interest rate swap position, but it may not be feasible or desirable if the swap is no longer profitable or necessary for the parties. For example, if the market interest rates have changed significantly since the swap was initiated, one party may be paying much more than the other party, and may want to exit the swap early.
- Negotiate a buyout option. This is when the parties agree on a termination fee that one party pays to the other party to end the swap. The termination fee is usually based on the market value of the swap, which is the present value of the future cash flows that the parties would have exchanged if the swap continued until maturity. The market value of the swap can be positive or negative, depending on the direction and magnitude of the interest rate movements. The party with a positive market value is the one who receives the termination fee, while the party with a negative market value is the one who pays the termination fee.
- Offset the original swap. This is when the parties enter into another swap that has the opposite terms of the original swap, such as swapping fixed for floating instead of floating for fixed, or swapping a different interest rate index, or swapping a different notional amount. The effect of this method is to cancel out the cash flows of the original swap, so that the parties are effectively out of the swap position. However, the parties still have to pay the fees and margins for the new swap, which may not be optimal.
- Sell the swap to someone else. This is when the parties find a third party who is willing to take over the swap position, either by assuming the rights and obligations of one of the original parties, or by entering into a mirror swap with one of the original parties. This method requires the consent of the other party and the third party, and may involve some transaction costs and risks.
- Use a swaption. This is when the parties have a pre-existing option to enter into another swap at a specified date and rate. The parties can exercise this option to offset the original swap, or to create a more favorable swap position. A swaption is a separate contract that has its own price and terms, and may not be available for all swaps.
Basic Theory:
An interest rate swap typically involves two parties exchanging fixed and floating interest rate cash flows. Closing out a swap position may be necessary for various reasons, such as changing market conditions or risk management strategies. The process involves determining the termination value of the swap, which is the net present value (NPV) of the remaining cash flows.
Procedures:
- Gather Information: Collect details about the interest rate swap, including the notional amount, fixed and floating rates, payment frequency, and the remaining time to maturity.
- Calculate Future Cash Flows: Use the swap terms to estimate future fixed and floating cash flows until the maturity date.
- Discount Future Cash Flows: Discount the future cash flows back to the present using the appropriate discount factor.
- Calculate Termination Value: The termination value is the difference between the present value of remaining fixed and floating cash flows.
- Execute the Transaction: Once the termination value is determined, the parties can settle the interest rate swap, and the position is closed.
Explanation – Scenario:
Let’s consider a scenario where Party A entered into a 5-year interest rate swap with Party B. The notional amount is $10 million, and Party A receives a fixed rate of 4%, paying a floating rate based on the 6-month LIBOR.
Assuming the current date is the midpoint of the third year, Party A decides to close out the swap position.
- Gather Information:
- Notional Amount (N) = $10,000,000
- Fixed Rate (F) = 4%
- Floating Rate (LIBOR) = 3.5%
- Remaining Maturity = 2 years and 6 months
- Calculate Future Cash Flows:
- Fixed Cash Flow = N * F * (Time to next payment)
- Floating Cash Flow = N * LIBOR * (Time to next payment)
- Discount Future Cash Flows: Use appropriate discount factors for fixed and floating cash flows.
- Calculate Termination Value:
- Termination Value = Present Value of Fixed Cash Flows – Present Value of Floating Cash Flows
- Execute the Transaction: Settle the termination value, and the interest rate swap position is closed.
Excel Calculation:
=PV(Fixed Rate, Remaining Periods, Fixed Cash Flow) - PV(Floating Rate, Remaining Periods, Floating Cash Flow)
Results:
Assuming the present value of fixed cash flows is $5 million, and the present value of floating cash flows is $4.8 million, the termination value is $200,000.
Other Approaches:
- Market Quotes: Obtain market quotes for similar interest rate swaps and use them to estimate the termination value.
- Bilateral Negotiation: Parties can negotiate the termination value based on mutual agreement, considering market conditions and risk considerations.
