A swap rate is the rate that is associated with the fixed portion of a swap. Typically, this rate is calculated based on what is happening in the market where the securities involved are traded. This determines what rate must prevail in order for the swap to actually be executed. In most instances, this rate will reflect the current market rate, less any premiums that may be added.
The exact setting in which the swap rate is employed makes some difference in how it is determined. For example, if the rate is associated with currency swaps, it is usually based on the difference that exists between the spot rate and the forward exchange rate for that currency. The difference, whether it is positive or negative, is normally presented as points.
In lending situations, the rate will often be calculated based on the fixed rate leg of relevant interest rate swaps. It is not unusual for financial institutions to make use of the swap rate as a means of arranging the borrowing rates that apply when one institution lends funds to another. At that point, the fixed rate and the swap rate are very similar, if not identical. Over time, the swap rate is subject to change, increasing or decreasing, depending on what is occurring within the economy.
In some markets, especially emerging markets, the swap rate is often considered to be a more reliable indicator of the health of the marketplace than other calculated rates. This is true when government bond markets within a given marketplace are considered underdeveloped. Rather than basing the benchmark curve on the treasury yield, utilizing the swap curve derived from the rate is often considered to be a better approach.
Since the swap rate can increase beyond the fixed rate over time, or drop well below that fixed rate, lenders and investors tend to consider closely what is likely to occur in the marketplace in the future, and how those shifts will affect the rate in both the short term and the long term. Doing so helps both parties to determine what degree of risk is being assumed, and if the swap is in the best interests of everyone involved, given each party’s desires for the outcome of the swap. Understanding the market, and how it can affect the currency involved, or have an impact on the lending between institutions, is essential if both parties are likely to gain what they want from the business relationship.
