Introduction to Corporate Finance

ONLINE CHAPTER

counterparty in the swap contract is effectively accessing the other counterparty’s cash flows, another

key advantage is that they may be able to borrow at a more attractive rate than if they were to borrow

directly. Remember that rates at which companies can borrow reflect the perceived risk of lending to

these companies (and hence their credit rating). A company with a higher credit rating should be able to

borrow at a lower rate than a company with a lower credit rating.

We will concentrate on the most common types, interest rate swaps and currency swaps. According

to a survey by the Bank for International Settlements, the total notional volume of over-the-counter

derivative contracts outstanding totalled more than $630 trillion at December 2014, with interest rate

swaps accounting for the bulk ($505 trillion) of this total.^9 It is important to note that, like forward

contracts, swap contracts are over-the-counter instruments and subject to default risk. For this reason,

swap market participants enter into contracts only with parties that they know and trust.

Interest Rate Swaps

An interest rate swap is the most common type of swap transaction. In a typical interest rate swap, one

party will make fixed-rate payments to another party in exchange for floating-rate payments. This is often

called a fixed-for-floating interest rate swap. As in the FRAs discussed earlier, the interest payments on a

fixed-for-floating swap will be based on a hypothetical principal amount called the notional principal.

The actual cash flows that are exchanged during the life of the swap will be the periodic net difference

between the respective interest payments. In contrast to currency swaps (discussed later in the chapter),

the notional principal is not physically exchanged.

Figure 23.6 illustrates the structure of a fixed-for-floating swap. The party making fixed-rate

payments, Company A, promises to make fixed-rate payments based on some notional principal amount

to a financial intermediary in exchange for floating-rate payments. In this example, as in many swap

transactions, an intermediary has arranged the swap and is acting as the counterparty to both contracts.

The contract calls for Company A to pay the intermediary 8% per year based on a notional principal of

$10 million. In return, the intermediary will pay Company A the six-month LIBOR applied to the same

$10 million notional principal amount. In practice, only the interest differential is exchanged between the

intermediary and Company A.

At the same time that the intermediary and company agree to swap interest payments, the intermediary

enters into an agreement to pay a fixed rate of interest to the floating-rate payer, Company B, in exchange

for a floating rate. In this example, the intermediary agrees to pay.

Company B 7.85% in exchange for the six-month LIBOR. The intermediary’s compensation is the

spread between the fixed rate received from Company A and the fixed rate paid to Company B.

interest rate swap
A swap contract in which two
parties exchange payment
obligations involving different
interest payment schedules

fixed-for-floating interest
rate swap
Typically one party will make
fixed-rate interest payments
to another party in exchange
for floating-rate interest
payments

interest differential
The difference between the
fixed and floating interest
rates that is exchanged in an
interest rate

FIGURE 23.6 TYPICAL STRUCTURE OF A FIXED-FOR-FLOATING INTEREST RATE SWAP

Swaps allow companies that can borrow fixed-rate debt more cheaply, but wish to borrow floating-rate debt, to swap

payment obligations with companies that can borrow floating-rate debt more cheaply but prefer to borrow fixed-rate debt.

6-month

LIBOR

6-month

LIBOR

Fixed-rate payer

(Company A)

Intermediary Floating-rate payer

(Company B)

8% 7.85%

9 These figures were obtained at http://www.bis.org/statistics/d5_1.pdf.