Delayed Rate Setting Swap

What Is a Delayed Rate Setting Swap?

The term delayed rate setting swap refers to a type of derivative contract that starts immediately but whose coupon is set at a future date. A delayed rate setting swap is a type of interest rate swap that focuses on the spread that the parties in the agreement can expect. When traders execute a delayed rate setting swap, they agree to exchange cash flows or assets, but only on a fixed date in the future. The spread is typically based on a benchmark interest rate.

Key Takeaeways

How a Delayed Rate Setting Swap Works

A swap is an over-the-counter agreement that involves two parties. Both agree to exchange cash flows for a certain period of time. They use a variable, such as interest rates, commodity or equity prices, or exchange rates, at the onset of the contract. There are many different types of swaps, including interest rate swaps, currency swaps, zero-coupon swaps, and commodity swaps.

A delayed rate setting swap is a type of interest rate swap. This kind of swap is also called a deferred rate setting or a forward swap. It involves the use of a fixed-for-floating rate swap. One is based on a fixed interest rate while the other is based on a floating rate. The spread or difference between these two is determined at the time the swap is initiated. But the actual rates aren't set until a later date.

For instance, the spread on such a delayed rate setting swap may be determined to be 100 basis points (or 1%) when the contract is set. A few days after the parties enter the swap, the counterparties may subsequently define the floating interest rate as the London Interbank Offered Rate (LIBOR) + 1%.

Most delayed rate setting swaps begin shortly after the spread terms are determined. Once the actual swap interest rates are set, a delayed rate setting swap acts like a regular interest rate swap. But the one difference from a regular interest rate swap is that a delayed rate setting swap adds an additional element of risk since both parties have contracted for a rate that will be set at a time in the future.

The benchmark interest rate, which is what each party focuses on as the spread, provides both parties with a proxy.

Special Considerations

Interest rate swaps are financial contract agreements that are exchanged between institutional investors. Swaps can be listed on institutional trading exchanges or negotiated directly between two parties.

Interest rate swaps are a form of risk management. As such, they allow institutions to swap fixed-rate obligations for floating-rate cash flows or vice versa. In a standard interest rate swap, the two sides of the transaction will typically involve a floating rate and a fixed rate. Both parties have the opportunity to speculate on their view of the interest rate environment.

The fixed-rate counterpart agrees to pay a fixed rate of interest on a specified amount for the benefit of receiving a floating rate. The fixed-rate counterpart generally believes that the outlook for rates is increasing and seeks to lock in a fixed-rate payout in receipt for a potentially rising floating rate that will create profit from the cash flow differential.

A floating rate counterpart takes the opposite view and believes that rates will fall. If interest rates fall, they have the advantage of paying a lower rate of interest that may fall below the fixed rate, with the cash flow differential in their favor.

Benefits of Delayed Rate Setting Swaps

A delayed rate setting swap can be beneficial for several reasons. It provides liquidity immediately and in the future and allows parties to remove volatility from their balance sheets. It is also beneficial when a counterparty finds the offered spread favorable to market conditions.

Let's say two counterparties agree to fixed and floating rate terms based on the one-year Treasury plus 50 basis points. The spread differential between the fixed and floating rates is zero while the actual base rate is set when the swap begins in the future.

The fixed-rate payer believes this rate will be favorable at the onset of the contract. They also believe that rates will rise with the floating rate cash flows providing a profit. As is typical for swap positions, the floating rate counterparty believes rates will fall in their favor.