Delayed Start Swap

Ash is working on this type of swap!

This is a swap in which the cash flows from one index are exchanged with cash flows from another index. What makes this swap a delayed swap is that the start date of the swap is not immediate. Delayed start swap is a risk reduction measure, just like any other swap. Financial managers will use this type of swap to match incoming cash flows with their outgoing cash flows. An unique trait of this kind of swap is that the starting contract dates for the two cash flows are different. Following is an example designed to clarify the concept.

Suppose that there are two cases of borrowing for 1 year, Case A and Case B.

In Case A, the CFO borrows \$100,000 for six months at a known rate, say 10%. He rolls over this loan another six months at the prevailing rate, say 11%, for another six months. There is usually fees attached to loan rollovers. Say in this cast, it is \$200.

In Case B, the CFO borrows for 1 year at a fixed known rate, say 10%.

This CFO can simulate a loan lasting six months, starting in six months by borrowing for one year and simultaneously lending for six months. He can borrow \$100,000.00 at 10% and lend this same \$100,000.00 right away at 12%. This way he will be matching interest payment cash outflow with the interest from his borrower. In this case, the CFO would come out ahead by \$1,000. Here is how.

In six months he would have to pay \$5,000 interest to his loaner. At the same time, he will receive interest from his borrower worth \$6,000. He is coming out ahead by \$1,000!

One year later, he will again have to pay an interest payment of \$5,000. When we subtract the \$1,000 gain from the previous six months from the \$5,000 this CFO's actually borrowing cost amounts to \$4,000. This is a 4% interest rate. This then is his effective forward rate on this loan.

http://www.finpipe.com/exswaps.htm

page revision: 3, last edited: 01 Oct 2008 20:01