Swap Mark-to-Market: a Worked Example

A borrower that swaps floating for fixed agrees to pay one rate for years whatever the market does. On the day the swap is struck its fixed rate matches the market, so its value is close to zero, a little against the customer by the bank's margin and credit charge. After that, every movement in rates changes what the remaining payments are worth. If rates fall, the borrower is paying above what a new swap would cost, and the swap is a liability to it and an asset to the bank. If rates rise, the reverse.

A bank counts a value in its own favour as money the borrower owes it in all but name: the amount it would lose if the borrower defaulted and the swap were closed. That current exposure, plus an allowance for how far it could grow, is what the swap uses of the borrower's derivative credit limit. The exposure and the borrower's risk of default tend to rise together, since rates often fall in a downturn that is also weakening the borrower, the pattern called wrong-way risk.

That is the shape of it. A bank's valuation uses the whole swap curve rather than one rate, the actual payment dates and any amortising notional, and discounts each payment separately. The figure on a valuation statement is usually a mid-market value. A price to close the swap is a different number: it adds the bank's dealing spread and, often, adjustments for credit and funding, so the cost of an actual close-out is commonly somewhat worse for the customer than the statement suggests.

A ski-field operator, constructed for this page like every figure in it, borrowed US$16m on a floating rate and swapped it to a fixed 4.40%. Four years remain. The market swap rate for four years is now 3.40%. Annual payments are assumed for simplicity:

The two outcomes are not mirror images, because the higher rate also discounts the payments more heavily. In the first, three things follow. The bank books about US$589,000 of current exposure against the derivative limit, before its allowance for further falls. Its all-monies security covers the swap as well as the loan, so a lender measuring debt against the ski field's value may add the swap to the debt. And the operator, offered a cheaper loan by another bank, finds that the switch costs about US$589,000 plus the bank's adjustments, because the old swap has to be closed or moved.

Moving it is possible. The swap can be novated, transferred to the new lender, which then holds a swap fixed above market and needs its own credit approval to take it. In the second outcome the operator holds an asset, and closing the swap would bring cash in.

The arithmetic is the same; the home is different. A fixed-rate loan carries its fixed rate inside the loan, and the cost of ending it early appears only when the loan is repaid, calculated under the loan agreement's own break cost clause. A floating loan with a swap separates the two: the loan can be repaid at par, and the swap has a value every day, reported, valued, and able to run in the borrower's favour. Whether a fixed-rate loan's break clause passes a gain back to the borrower depends on its wording.

The accounts treat them differently as well. Businesses reporting under IFRS-based standards, as larger companies do in New Zealand and Australia, or under FRS 102 in the UK, carry the swap on the balance sheet at fair value, with changes going through profit or loss or, under cash flow hedge accounting, largely through a hedging reserve. Many smaller New Zealand and Australian companies are not required to prepare general purpose accounts, and a UK micro-entity reporting under FRS 105 does not use fair value, so the accounts a smaller borrower gives the bank may not show the swap's value at all. A lender reading those asks for the bank's valuation.

DEFINED IN ONE PARAGRAPH → · BREAK COST, DEFINED → · A SWAP, FROM THE BORROWER'S SIDE →

It decides refinances, sales and enforcement. In a refinance the outgoing bank's payout figure includes the swap's close-out amount unless the swap is novated, and an incoming lender's offer that ignores it is not the offer it appears. In a sale of the asset, the swap outlives the loan unless it is closed. On a default, the ISDA Master Agreement, through the elections in its ISDA Schedule that tie it to the loan, usually lets the bank terminate. The close-out amount, broadly the mark-to-market adjusted to a replacement price, then becomes payable and, when it is in the bank's favour, joins the debt it recovers from the security.

At annual review the lender compares the exposure it approved with the current value and its updated estimate of how far that could grow. It also reads the value beside the hedge ratio: if the loan has amortised below the swap's notional, the excess swap is no longer hedging anything, and its mark-to-market is a position the borrower has taken without meaning to. Covenant definitions vary on whether the value counts as debt; some include it, others count it only once the swap is closed.

REFINANCING AND SWITCHING BANKS → · THE ISDA SCHEDULE → · WRONG-WAY RISK →