What is the Swap Rate?
The swap rate is the fixed rate of a swapSwapA swap is a derivative contract between two parties that involves the exchange of pre-agreed cash flows. The cash flows are usually determined using the determined by the parties involved in the contract The swap rate is demanded by a receiver (i.e., the party that receives the fixed rate) from a payer (i.e., the party that pays the fixed rate) to be compensated for the uncertainty regarding the fluctuations in the floating rate utilized in a swap. The swap rate can be found in either interest rate swapsInterest Rate SwapAn interest rate swap is a type of a derivative contract through which two counterparties agree to exchange one stream of future interest payments for another, based on a specified principal amount. In most cases, interest rate swaps include the exchange of a fixed interest rate for a floating rate. or currency swap. It also referred to as the reference rate, and is typically based on LIBORLIBORLIBOR, which is an acronym of London Interbank Offer Rate, refers to the interest rate that banks charge other financial institutions for a short-term loan maturing from a day to 12 months. LIBOR acts as a benchmarking base for a short-term interest rate for the interest prices of securities like currency swaps, for interest rate swaps.
Swap Rate in Interest Rate Swaps
The most commonly encountered design of interest rate swaps involves the exchange of the fixed interest rate for the floating interest rateFloating Interest RateA floating interest rate refers to a variable interest rate that changes over the duration of the debt obligation. It is the opposite alternative to a fixed interest rate loan, where the interest rate remains constant throughout the life of the debt.. The floating interest rate is typically expressed as a value of a variable index such as LIBORLIBORLIBOR, which is an acronym of London Interbank Offer Rate, refers to the interest rate that banks charge other financial institutions for a short-term loan maturing from a day to 12 months. LIBOR acts as a benchmarking base for a short-term interest rate for the interest prices of securities like currency swaps, plus or minus a spread. In such a case, the fixed interest rate is referred to as the swap/reference rate.
In interest rate swaps, the swap/reference rate is used to determine the total value of the swap’s fixed leg, which must be equal the total value of the floating leg of the swap. After the swap becomes effective, the swap rate remains the same until the swaps’ maturity while the floating interest rate is reset periodically at predetermined dates, based on the fluctuations of the index to which the rate is attached.
Swap Rate in Currency Swaps
Similar to interest rate swaps, currency swaps are a popular type of swaps. Currency swaps may come in several forms. One of them includes the fixed vs. floating rate currency swaps. In currency swaps, the swap/reference rate is referred to as the exchange rateFixed vs. Pegged Exchange RatesForeign currency exchange rates measure one currency's strength relative to another. A strong currency is considered to be one that is valuable, and this manifests itself when comparing its value to another currency. The strength of a currency depends on a number of factors such as its inflation rate associated with the fixed leg of a currency swap.
In currency swaps, the swap rate is primarily used as the exchange rate to convert the principal notional amounts set in different currencies. The principal notional amounts are specified prior to the start of the swap’s agreement. Like interest rate swaps, in currency swaps, the reference rate remains unchanged until the swap’s maturity.
Related Readings
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certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:
- Credit Default SwapCredit Default SwapA Credit Default Swap (CDS) is an agreement that protects the buyer against default. Swaps work like an insurance policy where a buyer can buy protection against an unlikely event that may affect the investment.
- Hedging ArrangementHedging ArrangementHedging arrangement refers to a settlement between two parties whose aim is to reduce the level of future risks in the event of an adverse price movement of an asset. In a literal definition, hedging means a sort of insurance cover to protect a given asset from future risks. But in the financial market, it’s more of
- Interest Rate RiskInterest Rate RiskInterest rate risk is the probability of a decline in the value of an asset resulting from unexpected fluctuations in interest rates. Interest rate risk is mostly associated with fixed-income assets (e.g., bonds) rather than with equity investments
- Swap SpreadSwap SpreadSwap spread is the difference between the swap rate (the rate of the fixed leg of a swap) and the yield on the government bond with a similar maturity
