What it means
An ordinary interest rate swap starts within a day or two of being agreed. A forward swap, sometimes called a forward-starting swap or a deferred start swap, keeps the same structure but pushes the first exchange of payments out to a chosen future date.
It is described by two numbers, such as a 2x7 swap, meaning a five-year swap that begins in two years. The fixed rate on a forward swap is not the current swap rate; it is the rate implied by the market's expectation of borrowing costs over the later period, which is worked out from the yield curve.
The typical user is a company with a known future financing need. A business planning to refinance a large loan in two years can fix the fixed rate now, removing the risk that long-term rates rise sharply between the decision and the refinancing date.
Forward swaps also appear in currency form, where a company that will acquire an overseas subsidiary in a year's time can fix both the exchange rate and the interest terms on the debt it will raise to fund it. Pension schemes use them too, to match liabilities that begin some years ahead.
The important caution is that entering the swap creates a real obligation with a market value that starts moving immediately. If the underlying refinancing does not happen, the company must either unwind the swap at whatever the market value is by then or live with a hedge that no longer matches anything.
In practice
Real-world examples.
Example
A utility knows a $300,000,000 bond matures in three years and expects to refinance with floating rate bank debt. It enters a forward-starting swap now to convert that future floating exposure into a fixed rate, so its long-range tariff filing can use a firm financing cost.
Example
A property fund exchanging contracts on a development that completes in eighteen months uses a forward swap to fix the rate on the loan it will draw at completion. The fund is protected from a rate rise during the build, although it also gives up any benefit if rates fall.
Example
A defined benefit pension scheme with payments beginning in seven years enters forward-starting swaps rather than buying bonds today. The approach hedges the interest rate sensitivity of the liabilities while leaving the scheme's current cash free to stay invested in growth assets.
Formula
Calculation
The forward swap rate is derived from the zero rates for the two relevant maturities: forward rate = ((1 + long rate) to the power of the long period / (1 + short rate) to the power of the short period), all raised to the power of 1 divided by the length of the forward period, then minus 1.
Suppose the seven-year zero rate is 4.20% and the two-year zero rate is 3.00%, and a company wants the rate on a five-year swap starting in two years, that is a 2x7 forward swap.
Growth over seven years = 1.042 to the power of 7 = 1.33375.
Growth over two years = 1.030 to the power of 2 = 1.06090.
Ratio = 1.33375 / 1.06090 = 1.25719.
Annualised over five years = 1.25719 to the power of 0.2 = 1.04684.
Forward swap rate = 4.68%.
If the company locks that 4.68% on a $25,000,000 notional and floating rates over those five years average 6.18%, the swap saves 1.50% a year, or $25,000,000 x 1.50% = $375,000 annually, and $1,875,000 across the full five years.Case study
Seen in the real world.
This is an illustrative scenario using an invented company. Marlow Bridge Water, a fictional regional water utility, had $25,000,000 of debt maturing in two years and a regulator that set customer tariffs five years at a time. The chief financial officer's worry was not the current rate but the risk that the refinancing would land in a much more expensive market halfway through a fixed tariff period.
The utility entered a 2x7 forward swap at a fixed rate of 4.68%, matching the notional and the term of the planned refinancing. Nothing was paid or received for two years; the swap simply sat on the balance sheet with a value that moved with the market.
By the time the refinancing came round, short-term rates had risen and the utility's floating borrowing averaged 6.18% over the following five years. The swap paid the difference, saving the illustrative company about $375,000 a year, and, more importantly for its board, allowed the tariff submission to be built on a financing cost that turned out to be accurate.
Watch out
Common mistakes.
- Assuming the forward swap rate equals today's swap rate, when it is derived from the shape of the yield curve and can be materially higher or lower.
- Treating the swap as dormant until it starts, when its market value moves from day one and must be reported.
- Sizing the swap on an optimistic funding plan, which leaves an oversized hedge if the borrowing is delayed or reduced.
Questions
People also ask.
How is a forward swap different from a forward rate agreement?
An FRA covers one short interest period, while a forward swap covers a series of periods over several years.
What happens if the planned borrowing never occurs?
The swap remains a live contract and must either be unwound at market value or left in place as an unmatched position.
Does a forward swap cost anything to enter?
Typically no premium is paid, but banks will require credit lines or collateral, and the pricing includes a spread for the bank.
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