What it means
In a standard interest rate swap one party pays a fixed rate and receives a floating rate, while the other does the reverse. The swap rate is the fixed rate that makes the deal worth zero to both sides at the outset.
If it were set any higher or lower, one party would be handing the other free value. The rate is not a guess about the future.
It is calculated from the market's expectations of floating rates over the life of the swap, which come from the yield curve (the pattern of interest rates for different maturities). A swap rate for five years is roughly the average of the expected floating rates over five years, adjusted for the timing of payments.
Banks quote swap rates for many maturities, such as two, five, ten and thirty years. Corporate treasurers use them in two main ways: to fix the cost of floating-rate debt by entering a swap at the quoted rate, and as a reference point when a lender prices a fixed-rate loan.
A fixed-rate loan is often priced as the swap rate plus a credit margin. Swap rates change every day as expectations for interest rates move.
A swap you entered at 3.5% becomes valuable if the market swap rate for the same remaining term later rises to 4.5%, because you are paying less than the new going rate. It becomes a liability if the market rate falls below 3.5%.
Since the end of the old interbank lending benchmarks, swap floating legs have moved to overnight reference rates in most major currencies. The idea of the swap rate is unchanged, but it is worth checking which floating benchmark a quote refers to.
In practice
Real-world examples.
Example
A property developer has a $20,000,000 floating-rate construction loan and wants certainty. The bank quotes a five-year swap rate of 4.1%, so the developer pays 4.1% fixed on the swap and receives the floating rate that offsets its loan interest.
Example
A bank prices a fixed-rate loan to a retailer. It takes the seven-year swap rate of 3.8%, adds a credit margin of 2.2% for the retailer's risk, and quotes an all-in rate of 6.0%.
Example
A treasurer at a software company sees that the ten-year swap rate has fallen by half a percentage point over a month. She asks the bank to refinance a fixed-rate bond issue early, because the lower swap rate suggests that new fixed borrowing will be cheaper.
Formula
Calculation
For a swap with annual payments:
Swap rate = (1 - Final discount factor) / Sum of all discount factors
A discount factor is the value today of receiving $1 at a future date. Suppose the discount factors for years 1, 2 and 3 are 0.97, 0.94 and 0.91.
Sum of discount factors = 0.97 + 0.94 + 0.91 = 2.82
Numerator = 1 - 0.91 = 0.09
Swap rate = 0.09 / 2.82 = 0.0319, or about 3.19%
On a notional (the reference amount) of $10,000,000, the fixed payment each year is $10,000,000 x 0.0319 = about $319,000. Check: the fixed leg is worth 0.0319 x 2.82 + 0.91 = 0.09 + 0.91 = 1.00 per $1, which equals the value of the floating leg, so the swap starts at zero.Case study
Seen in the real world.
Kestrel Logistics is an illustrative, fictional haulage group with a $30,000,000 floating-rate term loan. Its chief financial officer worried that rising rates would squeeze margins, and asked three banks for quotes on a five-year swap.
The quotes came back at 3.9%, 3.95% and 4.0%. Because the swap rate reflects market expectations, the spread between the quotes was small, and the CFO chose the lowest rate even though it came with slightly stricter collateral terms.
In the illustrative scenario rates then rose over the following two years. Kestrel kept paying 3.9% fixed while its loan interest climbed, and the swap offset the increase almost exactly, so the group's profit forecast stayed on track.
Watch out
Common mistakes.
- Thinking the swap rate is the same as the interest rate on a loan, when a loan rate also includes a credit margin for the borrower's risk.
- Assuming a swap rate is a forecast of what floating rates will actually be, when it only reflects what the market expects and prices in today.
- Ignoring the floating benchmark, since a swap rate quoted against one reference rate cannot be compared directly with a rate quoted against another.
Questions
People also ask.
Is the swap rate fixed for the life of the swap?
Yes, the fixed rate you agree on day one stays the same until maturity, but the market swap rate for new deals keeps moving.
Who sets the swap rate?
Nobody sets it centrally; it emerges from dealer quotes and market trading, and it is anchored by the yield curve.
Why can a swap have a value later if it started at zero?
Because market swap rates move, so the fixed rate you locked in becomes better or worse than the going rate for the remaining term.
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