Introduction to Corporate Finance

23: Introduction to Financial Risk Management

Figures 23.7 and 23.8 show payoff diagrams for Company A and Company B in the interest rate

swap. The x-axis of these diagrams represents possible spot rates for the six-month LIBOR applicable to

each six-month period. The y-axis represents the cash flow to the parties involved in the transaction. If

the contract calls for semiannual payments, the cash flow for Company A is [$10,000,000 × (LIBOR –

0.08)/2]. The cash flow for Company B is [$10,000,000 × (0.0785 – LIBOR)/2]. If the six-month LIBOR

is 7% at the start of the first six-month period, this is the floating rate applicable for the first six months.

At the end of this six-month period, Company A will pay the intermediary $50,000 [$10,000,000 ×

(0.07 – 0.08)/2]. The intermediary will pay Company B $42,500 [$10,000,000 × (0.0785 – 0.07)/2]. Six

months later, if the applicable six-month LIBOR is 8.5%, the intermediary will pay Company A $25,000

[$10,000,000 × (0.085 – 0.08)/2]. Company B will pay the intermediary $32,500 [$10,000,000 ×

(0.0785 – 0.085)/2]. These exchanges will take place every six months until the termination date.

Typically, these interest rate swaps arise because one party wanted to issue fixed-rate debt but chose

instead to issue floating-rate debt, either because the fixed-rate market was closed to this issuer or was

more costly. By entering a swap agreement, the floating-rate issuer can effectively obtain a fixed-rate

payment obligation. By paying a fixed rate and receiving a floating rate, this company can use the cash

inflows in the form of floating-rate payments to make the floating-rate payments on the debt that is

outstanding. The net effect of the swap agreement is to offset the floating-rate payments being paid on

the floating-rate debt with the floating-rate payments received on the swap. The fixed-rate payments

being made on the swap are all that remain. The counterparty in the swap contract (who has better

access to fixed-rate debt markets) achieves a preferred floating-rate pattern of payments. As mentioned

previously, rather than exchange gross amounts, the two parties will exchange only the net difference

between the two payment obligations, the interest differential; therefore, the party that has swapped a

fixed-rate payment obligation for one with a floating rate will lose (have to increase payment amounts) if

market rates rise and will benefit if market rates fall.

FIGURE 23.7 SEMIANNUAL NET CASH FLOW FOR THE FIXED-RATE PAYER IN A FIXED-FOR-FLOATING

SWAP WITH A NOTIONAL PRINCIPAL OF $10 MILLION

The actual interest payment made by the floating-rate payer to the fixed-rate payer at the end of each six-month period
depends on the floating interest rate (6-month LIBOR) at the beginning of each six-month period. The fixed-payer’s payment
is fixed, so the net payment received by the fixed-rate payer rises with increases in the 6-month LIBOR.

6-month

LIBOR (%)

$25,000

0

7% 8% 8.5%

–$50,000

Semiannual net cash flow to the fixed-rate payer ($)

Betty Simkins, Oklahoma

State University

‘The most common

interest rate swap is the

fixed-for-floating swap.’

See the entire interview on

the CourseMate website.

Source: Cengage Learning

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