448 Planning and Forecasting
size and direction of the cash f lows are determined by an agreed upon formula
spelled out in the swap agreement—a formula that is contingent on the perfor-
mance of other underlying instruments. Due to this contingency on other un-
derlying assets, swaps are considered derivatives.
One easy type of swap to understand is the equity swap. Suppose Back
Bay Investment Management owns a large block of Standard & Poor ’s 500
stocks. Suppose another firm, Capital Bank owns a large block of NASDAQ
stocks. Back Bay would like to diversify into NASDAQ stocks, and simultane-
ously Capital Bank would like to diversify into S&P 500 stocks. The old fashion
way of achieving the desired objectives would be for each party to sell the
stocks they do not want, and reinvest the proceeds in the stocks they do want.
Such an approach is very expensive in terms of commissions. A much cheaper
alternative is for each party to keep their own portfolio intact, and arrange be-
tween themselves an equity swap.
The swap agreement might dictate the following terms. For every per-
centage point that the NASDAQ stock index rises over the course of the year,
Capital Bank will pay Back Bay Investment Management $1 million. Simulta-
neously, for every percentage point that the S&P 500 rises over the course of
the year, Back Bay will pay Capital $1 million. Thus, if the NASDAQ index
rises 15% and the S&P 500 rises 11%, there will be a net payment of $4 million
from Capital to Back Bay. If in the following year the NASDAQ index rises
23% and the S&P 500 rises 29%, Back Bay will pay Capital $6 million on net.
The equity swap is illustrated in Exhibit 13.5.
In this equity swap, the “notional principal” is $100 million—that is, the
payments equal a base of $100 million times the indexes’ respective returns.
The net effect of the swap is to essentially convert $100 million of Back Bay’s
Standard & Poor ’s stocks into $100 million of NASDAQ stocks. Simultaneously,
$100 million ofCapital Bank’s NASDAQ stocks will now perform as if they
were $100 million of Standard & Poor’s 500 stocks. Both sides keep their assets
parked where they were, but they swap exposures on the notional principal.
Some arithmetic will prove the point that Back Bay’s portfolio will now
perform as if it were invested in NASDAQ stocks instead of S&P stocks. If
Back Bay did in fact own $100 million of NASDAQ stocks, by the end of the
first year, after the 15% rise in NASDAQ stocks, this portfolio would have
EXHIBIT 13.5 An equity swap.
Back Bay
Investment
ManagementCapital BankReturns on $100 million of
NASDAQ stock indexReturns on $100 million of
S&P 500 stock index