A forward-forward swap is a type of swap agreement that involves exchanging cash flows or assets on a fixed date in the future, but which also starts at a later date than the usual one or two business days. For example, two parties can agree to swap interest payments in six months, and then continue swapping for another six months after that. This way, they can lock in the swap rate today, but defer the actual payments until later.
A forward-forward swap can be useful for hedging against future interest rate or exchange rate movements, or for engaging in arbitrage or speculation. It can also be seen as a combination of two forward contracts, one with a near-month maturity and the other with a far-month maturity. For instance, a three-month swap and a nine-month swap can form a forward-forward swap that begins in three months and ends in nine.
The calculation of the swap rate for a forward-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 interest rates or exchange rates over the swap period. 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, using the appropriate discount factors and forward rates.
Basic Theory:
A forward-forward swap is essentially a combination of two consecutive forward contracts, allowing parties to exchange cash flows at two different future dates. This instrument is commonly used to hedge interest rate risk, speculation, or managing cash flow expectations.
In a forward-forward swap, two parties agree to exchange fixed interest payments over two different time periods. Each forward contract has its own notional principal, interest rate, and maturity date. The formula for calculating the forward-forward swap can be expressed as follows:
Forward-Forward Swap Value = N1 * (r2 - r1) * (T1 / (1 + r1 * T1))
Where:
N1is the notional principal of the first forward contract.r1is the interest rate of the first forward contract.T1is the time to maturity of the first forward contract.r2is the interest rate of the second forward contract.
Procedures:
- Identify Contract Terms:
- Determine the notional principal (
N1). - Establish the interest rates for both forward contracts (
r1andr2). - Define the time to maturity for the first forward contract (
T1).
- Determine the notional principal (
- Apply the Formula in Excel:
- Set up an Excel table with labeled columns for variables.
- Input the identified contract terms.
- Utilize the formula to calculate the forward-forward swap value.
- Interpret the Results:
- Analyze the calculated value to understand the cash flow implications for the specified time periods.
Scenario:
Let’s consider a scenario where Company A and Company B enter into a forward-forward swap:
N1= $1,000,000r1= 5%T1= 2 yearsr2= 6%
Excel Calculation:
| Variable | Value |
|---|---|
N1 |
$1,000,000 |
r1 |
5% |
T1 |
2 years |
r2 |
6% |
Forward-Forward Swap Value = $1,000,000 * (0.06 – 0.05) * (2 / (1 + 0.05 * 2))
Forward-Forward Swap Value ≈ $9,523.81
Result:
The forward-forward swap value in this scenario is approximately $9,523.81.
Alternative Approaches:
- Use Excel’s built-in financial functions like RATE or FV to simplify calculations.
- Employ more complex scenarios with varying interest rates or notional principals for a comprehensive analysis.
