Adjusted future swap

What Is Adjusted Future Swap?

An Adjusted Future Swap is a conceptual term referring to a financial instrument or strategy that combines elements of a traditional futures contract with the dynamic payment characteristics of a swap contract, particularly where pricing or payments are adjusted for specific factors beyond simple market movements. It falls under the broader category of Financial Derivatives, which are financial instruments whose value is derived from an underlying asset or benchmark. While not a standardized product name like an "interest rate swap," the concept of an Adjusted Future Swap encapsulates futures or forward-starting swaps where modifications are made to account for funding costs, credit risk, or other market complexities. These adjustments ensure that the instrument accurately reflects the true economic cost or benefit of the exposure over time.

History and Origin

The evolution of financial markets has continuously sought more precise and efficient ways to manage risk and gain exposure. The need for adjusted future swap-like instruments became more apparent with the increasing sophistication of derivative products and the recognition of various embedded costs and risks. Historically, standard futures and swaps were sufficient for many purposes. However, as markets matured and regulatory scrutiny increased, especially concerning factors like counterparty risk and funding, financial institutions began to incorporate finer adjustments into their derivative valuations. A significant driver for these adjustments, particularly in the swap market, has been the global transition away from interbank offered rates (IBORs) like LIBOR to new risk-free rates (RFRs) such as SOFR. This transition, which gained significant momentum after 2017 with official cessation of USD LIBOR settings in June 2023, necessitated extensive adjustments to existing and new interest rate swap agreements to account for the change in benchmark rates and associated spreads. The Alternative Reference Rates Committee (ARRC), convened by the Federal Reserve Board and the Federal Reserve Bank of New York, played a crucial role in facilitating this complex transition, which involved re-papering and adjusting trillions of dollars in contracts.¹²,¹¹

Key Takeaways

• An Adjusted Future Swap refers to a derivative instrument or strategy that combines features of futures and swaps, incorporating specific adjustments for factors like funding or credit risk.
• It is not a formal product name but describes instruments such as Adjusted Interest Rate (AIR) Total Return Futures, which blend futures' central clearing with swap economics.
• These adjustments aim to provide a more accurate reflection of the true economic value by accounting for elements beyond basic price movements.
• Key adjustments can include those for financing costs, dividends (in equity-linked products), and counterparty credit risk.
• The complexity of an Adjusted Future Swap requires robust valuation models and careful consideration of embedded risks.

Formula and Calculation

While there isn't a single universal formula for a generic "Adjusted Future Swap" due to its conceptual nature, the adjustments often applied to instruments that fit this description can be illustrated. For instance, in an Adjusted Interest Rate (AIR) Total Return Future, the value is composed of three main components: the total return index performance, the daily accrued financing, and the financing spread adjustment.¹⁰

The daily accrued financing component for an AIR Total Return Future is typically calculated based on a benchmark overnight floating rate, such as the Effective Federal Funds Rate (EFFR). The financing spread adjustment is determined by multiplying the day's closing index value by a traded Total Return Futures (TRF) Spread, and then by the time to maturity expressed as a fraction of a year (actual days/360).⁹

For an equity index total return swap, which an AIR Total Return Future aims to replicate, the financing payment is based on the swap's notional principal and an agreed-upon reference rate plus or minus a swap spread.⁸

Adjustments can also include Credit Valuation Adjustment (CVA) for counterparty credit risk and Debit Valuation Adjustment (DVA) for own credit risk when valuing over-the-counter (OTC) derivatives. CVA is defined as the difference between the risk-free portfolio value and the true portfolio value that accounts for the possibility of a counterparty's default.

The general principle of valuation for a derivative like a swap involves discounting future cash flows. For a fixed-for-floating interest rate swap, the value to the receive-fixed party can be represented as:
$V = NA \sum_{i=1}^{n'} (FS_0 - FS_t) \times PV_{t,t_i}$
Where:

• (V) = Value of the swap
• (NA) = Notional Amount
• (FS_0) = Original fixed swap rate
• (FS_t) = Current fixed swap rate for the remaining term at time (t)
• (PV_{t,t_i}) = Present value factor for time (t_i) as of time (t)
• (n') = Number of remaining payment periods

The "adjustment" in an Adjusted Future Swap comes from how (FS_t) or the effective discount rates might be modified for elements like credit risk, funding costs, or conversion factors relevant to the specific instrument.

Interpreting the Adjusted Future Swap

Interpreting an Adjusted Future Swap, or financial instruments structured with similar adjustments, requires a deep understanding of the specific factors being incorporated into its pricing. Unlike a standard futures contract, which primarily reflects the expected future spot price of an underlying asset, an Adjusted Future Swap builds upon this by integrating additional economic realities. For instance, if the adjustment accounts for financing costs, a higher adjustment could imply higher borrowing expenses for the party involved, impacting the effective return or cost of the position.

When evaluating such an instrument, market participants need to discern whether the adjustments accurately capture the intended economic exposures and risks. Understanding the methodology behind the "adjustment" is crucial for assessing the instrument's fair value and its implications for hedging or speculative strategies. Changes in the market's perception of these underlying factors (e.g., shifts in yield curve for funding adjustments, or changes in counterparty credit spreads for CVA) will directly influence the instrument's value.

Hypothetical Example

Consider a hypothetical "Adjusted Equity Index Future Swap" (AEIFS) designed to replicate the economics of an equity index swap using a futures-like structure. An investor wants exposure to the S&P 500 Total Return Index (which includes dividends) but prefers the central clearing and standardized nature of a futures contract, avoiding the bilateral counterparty risk of an OTC swap.

The AEIFS contract has a notional value of $1,000,000, linked to the S&P 500 Total Return Index. The "adjusted" part comes from a built-in daily financing rate plus a spread, mirroring the financing leg of an equity swap.

• Initial Setup: On January 1st, an investor goes long one AEIFS contract.
• Index Performance: Over the first month, the S&P 500 Total Return Index increases by 2%.
• Financing Adjustment: The daily financing rate (e.g., SOFR) averaged 5% annualized over the month. The agreed financing spread is +10 basis points (0.10%).
• Calculation Walkthrough:
  1. Index Gain: (1,000,000 \times 2% = $20,000).
  2. Daily Accrued Financing: The average daily financing cost would be based on (5% + 0.10%) = 5.10% annualized. For a month (approx. 30 days), this would be (1,000,000 \times 0.0510 \times (30/365) \approx $4,191.78).
  3. Net Adjustment: The investor receives the index gain but pays the financing cost. So, the net gain before any margin considerations would be ( $20,000 - $4,191.78 = $15,808.22 ).

This example illustrates how the AEIFS incorporates both the asset's performance and a financing adjustment, reflecting a more complete economic picture than a simple price-return future.

Practical Applications

Adjusted Future Swaps, or instruments with similar adjusted characteristics, find several practical applications across financial markets:

• Tailored Exposure: They allow market participants to gain very specific exposure to an underlying asset or rate, factoring in elements like funding costs or dividend reinvestment that might not be captured by plain vanilla instruments. For instance, Adjusted Interest Rate (AIR) Total Return Futures enable investors to replicate the economics of an equity index swap within a centrally cleared, futures framework, offering capital efficiency and reduced operational risk compared to bilateral OTC swaps.⁷
• Risk Management: Corporations and financial institutions use these instruments for precise hedging of complex exposures, where traditional futures or swaps might leave residual risks. For example, a firm with dynamic funding costs tied to an index might use an adjusted instrument to perfectly offset that variability.
• Arbitrage and Relative Value Trading: Sophisticated traders look for discrepancies between the theoretical fair value of an Adjusted Future Swap and its market price, seeking to profit from these mispricings. This often involves comparing the instrument's implied financing or credit components against prevailing market rates.
• Regulatory Compliance and Capital Efficiency: As regulatory frameworks like Basel III mandate capital charges for various risks, including Credit Valuation Adjustment (CVA) on derivative exposures, instruments that bake in these adjustments from the outset can offer better capital treatment. CVA is an adjustment to the fair value of derivative instruments to account for counterparty credit risk and has a specific capital charge under Basel III.⁶ Practical methods for estimating CVA are widely used.⁵

Limitations and Criticisms

Despite their utility, instruments characterized as Adjusted Future Swaps come with their own set of limitations and criticisms:

• Complexity and Opacity: The "adjusted" nature inherently adds complexity. Understanding all the embedded assumptions, factors, and calculation methodologies can be challenging, even for experienced market participants. This can lead to a lack of transparency regarding the true economic exposure.
• Model Risk: The calculation of adjustments, especially for sophisticated factors like Credit Valuation Adjustment (CVA) or dynamic financing spreads, relies heavily on complex mathematical models. These models are simplifications of reality and are subject to inherent limitations, assumptions, and uncertainties. If a model is incorrect, misused, or its inputs are flawed, it can lead to significant financial losses.⁴,³ The Office of the Comptroller of the Currency (OCC) highlights that model risk increases with greater model complexity, higher uncertainty about inputs and assumptions, broader use, and larger potential impact.²
• Illiquidity: Depending on how bespoke or complex the adjustments are, these instruments may trade less frequently than standardized futures or plain vanilla swaps, leading to wider bid-ask spreads and difficulty in entry or exit.
• Data Challenges: Accurate pricing and risk management of Adjusted Future Swaps often require granular and reliable data inputs for all adjustment components. In nascent markets or for highly specific adjustments, obtaining such data can be difficult.
• Basis Risk: Even with adjustments, a perfect hedge or replication might not be achieved due to unexpected correlations, market dislocations, or changes in underlying assumptions, leading to basis risk.

Adjusted Future Swap vs. Adjusted Futures Price

While both terms involve "adjustments" and relate to future-oriented financial instruments, "Adjusted Future Swap" and "Adjusted Futures Price" refer to distinct concepts:

In essence, the Adjusted Futures Price is a modification of a futures contract's price to reflect all associated costs for physical delivery, acting as a cash alternative.¹ An Adjusted Future Swap, however, leans into the dynamic payment exchanges and bespoke nature of a swap, applying these to a forward-looking or futures-like structure, often to capture a more complex economic profile or mitigate specific risks not covered by a simple futures price.

FAQs

What is the main purpose of an Adjusted Future Swap?

The main purpose is to create a highly specific and economically precise exposure to an underlying market or asset, often by incorporating factors like financing costs, dividends, or credit risk into a future-dated or futures-like instrument. This allows for more refined risk management and tailored investment strategies.

Is an Adjusted Future Swap a standardized product?

Generally, no. "Adjusted Future Swap" is often a conceptual term or describes a category of bespoke or hybrid instruments, such as Adjusted Interest Rate (AIR) Total Return Futures. While these specific products might be standardized and traded on exchanges like other exchange-traded derivatives, the overarching concept of "Adjusted Future Swap" is broad.

How does central clearing affect an Adjusted Future Swap?

If an Adjusted Future Swap takes the form of a centrally cleared futures contract (like AIR Total Return Futures), it significantly reduces counterparty risk. Central clearinghouses stand between the two parties of the trade, guaranteeing performance and reducing the bilateral credit exposure that is inherent in over-the-counter (OTC) swap agreements. This also often improves liquidity and capital efficiency.

What kinds of "adjustments" are typically made?

Adjustments can vary widely but commonly include those for:

• Financing costs: Reflecting the cost of funding the underlying position.
• Dividends: Particularly in equity-linked instruments, ensuring the full return (price appreciation plus dividends) is captured.
• Credit risk: Incorporating a Credit Valuation Adjustment (CVA) to account for the risk of counterparty default.
• Conversion factors: For bond futures, these adjust for the deliverable bonds.

Why would an investor choose an Adjusted Future Swap over a traditional swap or future?

An investor might choose an Adjusted Future Swap to gain specific economic exposure that a standard future or swap might not provide. For example, they might want the capital efficiency and reduced counterparty risk of a futures contract while still capturing the comprehensive economic performance (e.g., including financing and dividends) of an over-the-counter (OTC) total return swap.