Investments, tenth edition

LIBOR Rate

6.5%

7.0%

7.5%

Interest income from bond portfolio 

(5 7% of $100 million bond portfolio)

$7,000,000 $7,000,000 $7,000,000

Cash flow from swap 

[5 (LIBOR 2 7%) 3 notional principal of $100 million]         (500,000)              0   

 

500,000

Total (5 LIBOR 3 $100 million)

$6,500,000 $7,000,000 $7,500,000

 Notice that the total income on the overall position—bonds plus swap agreement—

equals the LIBOR rate in each scenario times $100 million. The manager has, in effect, 

converted a fixed-rate bond portfolio into a synthetic floating-rate portfolio. 

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  C H A P T E R  

2 3

  Futures, Swaps, and Risk Management 

817

of $800,000, can agree to swap a given number of pounds each year for $800,000. By 

so doing, it effectively covers its dollar obligation and replaces it with a new pound-

denominated obligation. 

 

 

 Show how a firm that has issued a floating-rate bond with a coupon equal to the LIBOR rate can use swaps 

to convert that bond into synthetic fixed-rate debt. Assume the terms of the swap allow an exchange of 

LIBOR for a fixed rate of 8%. 

 CONCEPT CHECK 

23.6 

  

8

 Actually, things are a bit more complicated. The dealer is more than just an intermediary because it bears the 

credit risk that one or the other of the parties to the swap might default on the obligation. Referring to  Figure 23.6 , 

if firm A defaults on its obligation, for example, the swap dealer still must maintain its commitment to firm B. 

In this sense, the dealer does more than simply pass through cash flows to the other swap participants. 

 A pension fund holds a portfolio of money market securities that the manager believes are paying excel-

lent yields compared to other comparable-risk short-term securities. However, the manager believes that 

interest rates are about to fall. What type of swap will allow the fund to continue to hold its portfolio of 

short-term securities while at the same time benefiting from a decline in rates? 

 CONCEPT CHECK