The bank effectively trades the two swaps simultaneously. We start with the consideration of the two, respective at-market swaps – i.e., swaps that have a starting value of zero, where the fixed rates are determined in a manner that reflects the credit quality of the counterparties to the contract. For the purposes of the example, we assume that the at-market fixed rate for the bank/dealer swap is 0.75%, and the at-market fixed rate on the customer/bank swap is 40 basis points higher, or 1.15%.
As a practical matter, the bank will generally dictate the fixed rate on the customer/bank swap. Appreciating that the credit risk associated with lending to the customer is (or should) be reflected in the spread over LIBOR that’s specified by the loan agreement, the assumed 40 basis point differential between the two fixed rates in this example represents the compensation that the bank would require in connection with the incremental credit risk associated with fixed rate funding vs. floating rate funding. The higher fixed rate on the customer/bank swap relative to the bank/dealer swap is also justified given that the bank customer would likely have an inferior credit rating relative the bank. On that basis, the fixed rate that the customer pays on a pay fixed/receive variable swap should be higher than the fixed rate that the bank would pay on a similarly constructed swap. In any case, barring default,
the bank would end up earning this difference between these two fixed interest rates through the term of the swaps.
An alternative structure allows the bank to accelerate revenue recognition under this strategy by altering the terms of the bank/dealer swap. Specifically, the fixed rate on the bank/dealer swap could be adjusted upward from 0.75% to the same 1.15% rate that applies to the other swap, with a compensating day-one cash flow paid by the dealer to the bank in an amount that reflects the present value of the incrementally higher fixed interest payment that the dealer would receive. For the purposed of the example, we assume that present value effect to be $34,000.
The accounting for this strategy requires both swaps to be recorded on the balance sheet by the bank at their respective fair market values, with changes in values posted to earnings. The earnings effect includes swap settlements, as well as these mark-to-market adjustments. Note that because total swap results (mark-to-market changes plus settlements) are reported in earnings, swap accruals need not be specifically identified or independently accounted for. In fact, any explicit journal entries relating to swap accrual would cause a double counting if the total swaps’ results are otherwise correctly recorded.
Recall that at the time of the trade, the customer/bank swap is transacted with no initial net investment (i.e., no day-one settlement), such that no journal entry arises for that transaction on the trade date. On the other hand, a day-one settlement does occur from dealer to the bank for having marked up the fixed leg of their swap to mirror the customer/bank swap’s fixed rate. When the dealer makes a day-one settlement (typically paid T+2) to the bank, the correct journal entry is a debit of cash and a credit to the derivative account in the amount of the settlement. Our example assumes a day-one settlement of $34,000 (equal to the present value of the incremental 40 basis points). Thus, with the receipt of the cash, the bank/dealer swap has a liability worth $34,000 from the perspective of the bank and an asset of the same value from the perspective of the dealer. Following this initial settlement, both swaps would be marked-to-market through income. From the bank’s perspective, one of the swaps would be an asset; the other a liability.
As the fixed rates on both swaps have been set equal to each other, after that day-one settlement on the bank/dealer swap, all the following cash flows of the two respective swaps over the life of the transaction will be equal and opposite. That is, any subsequent settlements from the customer to the bank (or vice versa) would be a perfect offset to the settlements between the bank and the dealer. Despite these perfect offsets, however, the two respective swap valuations won’t be exactly equal because of credit quality concerns. In other words, the two swaps will not have identical balance sheet carrying values. They’re likely to be quite close, but they won’t be the same.