Adjusted average swap: Meaning, Criticisms & Real-World Uses

What Is Adjusted Average Swap?

An Adjusted Average Swap is a type of interest rate swap where one of the payment legs, typically the floating rate leg, is determined by calculating an average of an underlying benchmark interest rate over a specified period, often with an additional spread adjustment. This structure falls within the broader category of derivatives, financial contracts whose value is derived from an underlying asset or rate. The "average" component aims to reduce volatility inherent in daily rate fluctuations, while the "adjusted" portion often accounts for differences in credit risk or market conventions when transitioning from one benchmark to another, such as from LIBOR to SOFR.

History and Origin

The concept of interest rate swaps, from which the Adjusted Average Swap ultimately evolved, gained prominence in the early 1980s. The first recorded swap transaction, a currency swap between IBM and the World Bank in 1981, laid the groundwork for the development of the broader swaps market.¹² Interest rate swaps became widely used as financial instruments for managing interest rate risk.

The specific need for "adjusted average" methodologies became particularly pronounced with the global transition away from the London Interbank Offered Rate (LIBOR). LIBOR, once a dominant benchmark, faced scrutiny and calls for its cessation due to concerns over its reliability and instances of manipulation.¹¹ Regulators and market participants sought more robust, transaction-based alternatives. The Secured Overnight Financing Rate (SOFR) emerged as the preferred alternative benchmark for U.S. dollar-denominated financial products.¹⁰ Unlike LIBOR, which was a polled rate, SOFR is based on actual overnight repurchase agreement transactions, leading to greater stability and transparency.⁹ However, SOFR is an overnight rate, and for many products that previously used term LIBOR rates, an averaged or compounded version of SOFR, often with an adjustment for the historical spread between LIBOR and SOFR, was necessary to ensure economic consistency. This shift necessitated the development and widespread adoption of various averaged and adjusted SOFR formulations in swap contracts, thereby giving rise to structures that function as Adjusted Average Swaps. The Alternative Reference Rates Committee (ARRC) played a pivotal role in facilitating this transition, including recommending SOFR Term Rates and implementing initiatives like "SOFR First" for derivatives.⁷, ⁸

Key Takeaways

An Adjusted Average Swap calculates one leg's payment based on an average of an underlying reference rate over time.
The "adjusted" component often refers to a spread added to the averaged rate to account for market differences.
This swap structure is particularly relevant in the post-LIBOR environment, utilizing rates like SOFR.
Adjusted Average Swaps help mitigate the impact of daily rate volatility compared to single-point fixings.
They are a common tool in hedging strategies and risk management.

Formula and Calculation

The calculation for the floating leg of an Adjusted Average Swap typically involves compounding or averaging the daily observations of the chosen benchmark rate (e.g., SOFR) over an interest period, and then applying a spread adjustment. The payment on the floating leg can be calculated as:

\text{Floating Payment} = \text{Notional Principal} \times \left( \left( \prod_{i=1}^{N} \left(1 + \frac{\text{Rate}_i \times \text{Days}_i}{\text{Day Count Basis}}\right) - 1 \right) + \text{Spread Adjustment} \right)

Where:

(\text{Notional Principal}) = The agreed-upon principal amount on which interest payments are calculated (this amount is not exchanged).⁶
(\text{Rate}_i) = The benchmark rate (e.g., daily SOFR) on day (i).
(\text{Days}_i) = The number of calendar days that (\text{Rate}_i) applies.
(\text{Day Count Basis}) = The day count convention (e.g., 360 for actual/360).
(\text{N}) = The number of days in the interest period.
(\text{Spread Adjustment}) = A fixed spread added to the averaged rate, often used to align the new benchmark with historical levels of the rate it replaces (e.g., LIBOR).

The notional principal is a key variable in determining the size of the cash flows exchanged, even though it never changes hands. The other side of the swap will typically involve a fixed rate payment.

Interpreting the Adjusted Average Swap

Interpreting an Adjusted Average Swap involves understanding how its averaged floating rate responds to market conditions and how the spread adjustment impacts the overall cost or revenue stream. Because the floating leg is based on an average, it provides a smoother payment profile compared to a swap where the floating rate resets on a single day. This averaging effect can reduce the impact of sudden, temporary spikes or drops in the underlying financial instrument's reference rate.

The spread adjustment is crucial for entities transitioning existing contracts from a rate like LIBOR to a new rate like SOFR. This adjustment aims to minimize the economic value transfer that might otherwise occur due to inherent differences between the historical benchmark and the new, more robust alternative. For example, LIBOR historically included a bank credit risk component, which SOFR, as a secured rate, does not. Therefore, a positive spread adjustment is often applied to SOFR-based rates in legacy contracts to compensate for this difference. When evaluating an Adjusted Average Swap, participants assess how the averaged rate and the spread compare to their funding costs or investment returns, as well as their outlook on future interest rate movements.

Hypothetical Example

Consider Company A, a manufacturing firm, that has a loan with a floating rate tied to compounded SOFR plus a spread, resetting quarterly. To manage its interest rate risk, Company A enters into an Adjusted Average Swap with Bank B.

Notional Principal: $10 million
Term: 2 years
Company A (Floating Leg Payer): Pays a fixed rate of 3.5% annually to Bank B.
Bank B (Floating Leg Payer): Pays compounded SOFR + 0.10% (10 basis points) to Company A. The SOFR is compounded daily over each quarterly period.

Scenario for Q1 (90 days):
Assume the daily SOFR rates average out to 2.80% over the first quarter, and the spread adjustment is 0.10%.

Bank B's Payment (Floating Leg):
The effective floating rate for the quarter would be the compounded average SOFR plus the spread adjustment. For simplicity, let's assume a simple average for this example's illustration:
Average SOFR (compounded) for Q1 = 2.80%
Floating Rate = 2.80% + 0.10% = 2.90%
Quarterly Payment = $10,000,000 \times 2.90\% \times \frac{90}{360} = \$72,500$
Company A's Payment (Fixed Leg):
Annual Fixed Rate = 3.50%
Quarterly Payment = $10,000,000 \times 3.50\% \times \frac{90}{360} = \$87,500$
Net Payment:
Company A pays Bank B the net difference: $87,500 (fixed) - $72,500 (floating) = $15,000.

In this scenario, Company A pays a net of $15,000 to Bank B for the quarter, effectively converting its floating-rate loan exposure into a fixed-rate obligation, smoothed by the averaged SOFR calculation.

Practical Applications

Adjusted Average Swaps are widely used in modern capital markets for a variety of purposes, particularly following the global shift from LIBOR to alternative reference rates. Their primary applications include:

Risk Management: Corporations and financial institutions use these swaps to hedge against fluctuating interest rates on their debt or assets. By exchanging a floating-rate payment based on an averaged benchmark for a fixed rate, they can stabilize their cash flows and mitigate the uncertainty of interest rate movements.
Transitioning Legacy Contracts: A significant application involves adjusting pre-existing LIBOR-linked contracts. As LIBOR ceased to be published, many contracts needed to transition to new benchmarks like SOFR. Adjusted Average Swaps, particularly those incorporating a spread adjustment, provide a mechanism to facilitate this transition while preserving the economic terms of the original agreement. The Alternative Reference Rates Committee (ARRC) has actively promoted the use of averaged SOFR for such transitions.⁵
Balance Sheet Management: Banks and large companies use these swaps to manage the asset-liability mismatches on their balance sheets, ensuring a more predictable earnings stream despite market volatility.
Regulatory Compliance: The Commodity Futures Trading Commission (CFTC) plays a crucial role in regulating the U.S. derivatives markets, including swaps, to ensure market integrity and participant protection.⁴ The move to robust, transaction-based rates like SOFR, often utilized in Adjusted Average Swaps, aligns with regulatory goals of reducing systemic risk.

Limitations and Criticisms

While Adjusted Average Swaps offer benefits, particularly in the post-LIBOR environment, they are not without limitations and potential criticisms:

Complexity: The calculation of averaged rates, especially compounded rates with day count conventions and potential observation shifts, can be more complex than simple point-in-time fixings. This complexity might lead to a lack of transparency for less sophisticated market participants.
Basis Risk: Despite efforts to harmonize new benchmarks, basis risk can still arise. This occurs when the reference rate used in the swap (e.g., averaged SOFR) does not perfectly track the funding costs or revenues of the underlying exposure it is meant to hedge. For instance, SOFR is a secured overnight rate, which may behave differently than an unsecured bank funding rate.
Liquidity in New Benchmarks: While liquidity in SOFR-linked swaps has grown significantly, especially since initiatives like "SOFR First" in 2021, some segments of the market might still prefer more established benchmarks or face challenges in transitioning existing systems.³ However, the Federal Reserve Bank of New York indicates that SOFR is now the dominant U.S. dollar interest rate benchmark.²
Counterparty Risk: Like all over-the-counter (OTC) market derivatives, Adjusted Average Swaps expose participants to counterparty risk—the risk that the other party to the agreement will default on its obligations. While central clearing helps mitigate this, it does not eliminate it entirely for all swap transactions. The Reuters article noted concerns where the dollar swap market could dry up entirely in stress tests.

¹## Adjusted Average Swap vs. Plain Vanilla Interest Rate Swap

The distinction between an Adjusted Average Swap and a Plain Vanilla Interest Rate Swap lies primarily in the calculation methodology of the floating leg and the context of their use.

Feature	Adjusted Average Swap	Plain Vanilla Interest Rate Swap
Floating Leg Calc.	Based on an average (e.g., compounded) of a benchmark rate over a period, often with a spread adjustment.	Typically based on a single, point-in-time fixing of a benchmark rate (e.g., historical LIBOR, or a simple reset of SOFR).
Primary Context	Prevalent in the post-LIBOR transition era, often incorporating SOFR or other risk-free rates with necessary adjustments.	Traditional and fundamental type of swap, exchanging a fixed rate for a floating rate, historically often LIBOR-based.
Volatility Impact	Averages out daily rate fluctuations, potentially leading to smoother cash flows.	Payments can be more sensitive to a single day's rate fixing.
Purpose (modern)	Facilitates transition from legacy benchmarks, hedges against averaged rate exposures.	General hedging of interest rate exposure, arbitrage.

The confusion often arises because an Adjusted Average Swap is, at its core, still an interest rate swap. However, the "adjusted average" modifier highlights a specific, often more complex, mechanism for determining the floating rate payment, particularly relevant in the era of benchmark rate reform.

FAQs

What is the main purpose of an Adjusted Average Swap?

The main purpose is to manage interest rate risk by exchanging fixed-rate payments for floating-rate payments, where the floating rate is calculated using an average of a benchmark rate over a period, often with an added spread. This is particularly useful for smoothing out volatility and facilitating transitions between benchmark rates.

How does the "average" part work?

Instead of taking a single rate on a specific date for the entire interest period, the floating payment is determined by observing the benchmark rate (like SOFR) over multiple days or the entire period, then compounding or averaging those daily rates. This averaged rate is then used to calculate the interest payment.

Why is a "spread adjustment" sometimes included?

A spread adjustment is often included, especially in swaps that transitioned from LIBOR to new benchmarks like SOFR. It helps account for the historical differences in the credit component and liquidity premium that were embedded in LIBOR but are typically not present in the new, often secured, risk-free rates. This ensures the economic value of the contract remains consistent.

Is an Adjusted Average Swap a complex financial instrument?

Compared to a basic loan, it can be more complex due to the derivative nature and the averaging calculation. However, for sophisticated financial institutions and corporations managing significant interest rate exposures, it is a standard financial instrument used in hedging strategies.

Who regulates Adjusted Average Swaps?

In the United States, the Commodity Futures Trading Commission (CFTC) oversees the derivatives markets, including swaps, to ensure fair and transparent trading practices. Similar regulatory bodies exist in other jurisdictions globally.