Valuing a Swap
When a municipal entity decides to engage in a swap contract, it will usually contact a swap dealer and the swap dealer will provide a quote for the swap. The quote will be for a customized over-the-counter contract. Presently, there is no exchange where swaps can be readily traded, and “over-the-counter” means the contract is not traded on an exchange. Unlike an option, a swap contract typically does not involve paying a premium to purchase the contract. This is because swaps have zero value at their start, meaning the present value of all future payments on each side of the swap are equal. A swap involves the exchange of payments between two parties on a specified day, called the settlement date. The period between the payments is referred to as the settlement period. The settlement date is usually set to occur on a quarterly or semi-annual basis, with semi-annual payments being the most common because they correspond with the interest payments that need to be made to the issuer’s bondholders.
Let’s pretend that the town of Popperville has issued variable-rate securities of $10,000,000 that they would like to exchange for a fixed rate. Popperville contacts a swap dealer. The swap dealer quotes a swap rate to Popperville. The swap rate is the fixed rate that the swap dealer (the receiver) requires in return for paying short-term variable interest rates over the course of the contract. This is the rate that the municipality will pay.
The swap rate is based on the swap forward curve, which reflects the market’s expectation of how the variable interest rate, usually SOFR, will behave over the payment period. At the time that the swap agreement is made, the quote will be the fixed rate that makes the present value of the fixed payments equivalent to the present value of all the future variable payments during the term of the contract, as determined by the swap forward curve. But because the forward curve changes over time, the value of