Understanding Swap Changes
Interest rate swaps start and end at zero value. The changes that happen in between can create a wild and bumpy ride.
Swaps change for two reasons: Time – making/receiving payments – and interest rates. With an upward sloping yield curve with an expectation of rising rates in the future, a pay fixed-receive variable swap predicts net payments in the beginning, followed by net receipts at the end:
If you assume that interest rates end up exactly as predicted at each quarter-end, the swap will build up an asset balance at the beginning of its life and then decrease back down to zero by swap termination:
So what does it mean if your swap is a liability? That happens when current projected reset rates are lower than originally predicted (i.e., the rate curve decreased). Whether this rate environment is good news or bad news depends on why you entered into the swap in the first place. Are you hedging variable rate debt?
- If you are 100 percent hedged, you are protecting future increases, but you’re not benefiting from the low-rate environment.
- If you are less than 100 percent hedged, you are benefitting from paying lower rates on the unhedged portion of your debt, while still protecting the bottom line from future increases in rates.
A frequent misconception is that rates are so low that swap liabilities can’t get any worse. How low can you go? Look at the fixed leg; if variable rates drop to zero, you will still owe the fixed leg of the swap.
The past few years have seen historically low rates. While the curve itself has moved up and down and changed shape, short-term LIBOR rates have remained very low, necessitating continued net swap payments. If you have hedge accounting, the loss on the swap is deferred and recognized on the balance sheet rather than the bottom line. Without hedge accounting, the ups and downs rocket through the P&L in an unpredictable fashion.
Still have questions or need help explaining your swap movements? Our team of interest rate hedging specialists is happy to talk. Click here to contact us, or call 408-350-8580.
– Ruth Hardie