Investments, tenth edition

 Example  23.6 

Interest Rate Swap 

bod61671_ch23_799-834.indd   815

bod61671_ch23_799-834.indd   815

7/25/13   2:01 AM

7/25/13   2:01 AM

Final PDF to printer

---

816 

P A R T   V I

  Options, Futures, and Other Derivatives

  Swaps and Balance Sheet Restructuring 

 Example 23.6 illustrates why swaps have tremendous appeal to fixed-income managers. 

These contracts provide a means to quickly, cheaply, and anonymously restructure the 

balance sheet. Suppose a corporation that has issued fixed-rate debt believes that interest 

rates are likely to fall; it might prefer to have issued floating-rate debt. In principle, it could 

issue floating-rate debt and use the proceeds to buy back the outstanding fixed-rate debt. 

But it is faster and easier to convert the outstanding fixed-rate debt into synthetic floating-

rate debt by entering a swap to receive a fixed interest rate (offsetting its fixed-rate coupon 

obligation) and paying a floating rate. 

 Conversely, a bank that pays current market interest rates to its depositors, and thus is 

exposed to increases in rates, might wish to convert some of its financing to a fixed-rate 

basis. It would enter a swap to receive a floating rate and pay a fixed rate on some amount 

of notional principal. This swap position, added to its floating-rate deposit liability, would 

result in a net liability of a fixed stream of cash. The bank might then be able to invest in 

long-term fixed-rate loans without encountering interest rate risk. 

 For another example, consider a fixed-income portfolio manager. Swaps enable the 

manager to switch back and forth between a fixed- or floating-rate profile quickly and 

cheaply as the forecast for the interest rate changes. A manager who holds a fixed-rate 

portfolio can transform it into a synthetic floating-rate portfolio by entering a pay fixed–

receive floating swap and can later transform it back by entering the opposite side of a 

similar swap. 

 Foreign exchange swaps also enable the firm to quickly and cheaply restructure its bal-

ance sheet. Suppose, for example, that a firm issues $10 million in debt at an 8% coupon 

rate, but actually prefers that its interest obligations be denominated in British pounds. 

For example, the issuing firm might be a British corporation that perceives advantageous 

financing opportunities in the United States but prefers pound-denominated liabilities. 

Then the firm, whose debt currently obliges it to make dollar-denominated payments 

payment of .07  3  $100 million for a payment of LIBOR  3  $100 million. The manager’s 

 net  cash flow from the swap agreement is therefore (LIBOR  2  .07)  3  $100 million. Note 

that the swap arrangement does not mean that a loan has been made. The participants 

have agreed only to exchange a fixed cash flow for a variable one.

 

 Now consider the net cash flow to the manager’s portfolio in three interest rate scenarios: