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Marking a Swap to Market

A swap can be marked to market when its settlement takes place by periodically readjusting its payments to market rates. The counterparty with a negative value pays the counterparty with a positive value on a periodic basis (daily, monthly, etc) the net value based on the agreed notional amount. Suppose, for example, that an XYZ company has entered into a 7-year swap as a fixed-rate payer of 7.5% against six-month LIBOR. It wants to mark this swap to market, say, after one year from its value date. The remaining life of the swap is six years. Therefore, the company has to compare its original swap to a 6-year swap on which it would be the fixed-rate receiver. If the company would receive in six years 6.5% against six-month LIBOR today, then the cash flows of the swap would be:

Swap Counterparty
Original Swap pay 7.5%
Receive LIBOR
Benchmark Swap receive 6.5%
pay LIBOR
net cashflow pay 1%

The LIBOR payments cancel each other out, but there would be a 1% left uncovered for each of the incoming six years. As a result, the marked-to-market value of the swap is expected to be minus 1% for each year remaining of its life. This implies that the company is a net payer of 1%, and the counterparty a net receiver of the same percentage.

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