Investments, tenth edition

23.7 

  The Swap Dealer 

 What about the swap dealer? Why is the dealer, which is typically a financial intermediary 

such as a bank, willing to take on the opposite side of the swaps desired by these partici-

pants in these hypothetical swaps? 

 Consider a dealer who takes on one side of a swap, let’s say paying LIBOR and receiv-

ing a fixed rate. The dealer will search for another trader in the swap market who wishes to 

receive a fixed rate and pay LIBOR. For example, Company A may have issued a 7% coupon 

fixed-rate bond that it wishes to convert into synthetic floating-rate debt, while Company B 

may have issued a floating-rate bond tied to LIBOR that it wishes to convert into synthetic 

fixed-rate debt. The dealer will enter a swap with Company A in which it pays a fixed rate 

and receives LIBOR, and will enter another swap with Company B in which it pays LIBOR 

and receives a fixed rate. When the two swaps are combined, the dealer’s position is effec-

tively neutral on interest rates, paying LIBOR on one swap and receiving it on another. Simi-

larly, the dealer pays a fixed rate on one swap and receives it on another. The dealer becomes 

little more than an intermediary, funneling payments from one party to the other.  

8

    The  dealer 

finds this activity profitable because it will charge a bid-ask spread on the transaction.

   

 This rearrangement is illustrated in  Figure 23.6 . Company A has issued 7% fixed-rate 

debt (the leftmost arrow in the figure) but enters a swap to pay the dealer LIBOR and receive 

a 6.95% fixed rate. Therefore, the company’s net payment is 7%  1  (LIBOR  2  6.95%)  5  

LIBOR  1  .05%. It has thus transformed its fixed-rate debt into synthetic floating-rate debt. 

Conversely, Company B has issued floating-rate debt paying LIBOR (the rightmost arrow), 

but enters a swap to pay a 7.05% fixed rate in return for LIBOR. Therefore, its net payment 

is LIBOR   1   (7.05%   2   LIBOR)   5  7.05%. It has thus transformed its floating-rate debt 

into synthetic fixed-rate debt. The bid-ask spread, the source of the dealer’s profit, in the 

example illustrated in  Figure 23.6  is .10% of notional principal each year. 

 

 

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