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A forward swap is an exchange of financial instruments between two parties that occurs at a future date. Typically, interest rates, currencies or commodities such as crude oil are swapped. A forward swap generally has a zero present day value, minus the swap dealer’s commission. Useful in hedging risks and in matching cash flows, forward swaps have historically been used to avoid industry regulations.
A forward swap is constructed in the same manner as a regular swap, but its start date is later. It can be referred to as a forward start swap, a delayed start swap, or a deferred start swap, depending on a financial institution’s conventions. As with other forward contracts, parties prefer to lock in terms today for future exchanges using a forward swap.
The most common swap is a fixed to floating interest rate swap. For example, company A only has access to a variable rate loan, but would prefer the stability of a fixed rate loan. Company B can borrow at a fixed rate, but would prefer the potential for gains that a variable rate provides. They decide to swap, where the swap rate is the fixed rate and the floating rate is some independent reference rate, such as the London Interbank Offered Rate (LIBOR) plus a certain number of points.
Today’s swap market is huge and includes many types of forward swaps. Interest rate swaps can be fixed to floating, floating to floating, or even fixed to fixed based on different currencies. In contrast with an interest rate swap where only the difference in rates are settled, a currency swap is an agreement to exchange principles as well as interest rates.
For instance, an American company wants to expand its business in Japan next year, and needs funds for a project lasting five years. The company could wait a year and hope for a favorable exchange rate, or try securing a loan in Japan. But it is easier and less risky to arrange a forward swap with a Japanese company which might be interested in locking in a lower interest rate available in US Dollars.
Other exotic forms of forward swaps exist. In an equity swap, dividends are swapped while voting power is retained. A swaption is a swap with an embedded option whether or not to engage in the swap at a future date. A swap transferring risk with a participating element (STRIPE), is a swap with a cap on the floating rate, used to reduce volatility in a buyer’s portfolio.
Generally traded over the counter (OTC), forward swaps can be tailored to fit each party's needs. One investor might use a forward swap to hedge interest rate or currency risk. Another investor might want to change obligations with annual settlement dates for obligations with monthly settlement dates. Win- win situations are created as risk is shifted towards those who want to bear it, creating a more efficient market.
Are embedded swaps toxic as they are made out to be, as they seem to have the same effect as stand alone products !
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