Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Risk Management: An
Introduction to Financial
Engineering
© The McGraw−Hill^821
Companies, 2002Commercial banks are the dominant swap dealers in the United States. As a large
swap dealer, a bank would be involved in a variety of contracts. It would be swapping
fixed-rate loans for floating-rate loans with some parties and doing just the opposite
with other participants. The total collection of contracts in which a dealer is involved is
called the swap book.The dealer will try to keep a balanced book to limit its net expo-
sure. A balanced book is often called a matchedbook.
Interest Rate Swaps: An Example
To get a better understanding of swap contracts and the role of the swap dealer, we con-
sider a floating-for-fixed interest rate swap. Suppose Company A can borrow at a float-
ing rate equal to prime plus 1 percent or at a fixed rate of 10 percent. Company B can
borrow at a floating rate of prime plus 2 percent or at a fixed rate of 9.5 percent. Com-
pany A desires a fixed-rate loan, whereas Company B desires a floating-rate loan.
Clearly, a swap is in order.
Company A contacts a swap dealer, and a deal is struck. Company A borrows the
money at a rate of prime plus 1 percent. The swap dealer agrees to cover the loan pay-
ments, and, in exchange, the company agrees to make fixed-rate payments to the swap
dealer at a rate of, say, 9.75 percent. Notice that the swap dealer is making floating-rate
payments and receiving fixed-rate payments. The company is making fixed-rate pay-
ments, so it has swapped a floating payment for a fixed one.
Company B also contacts a swap dealer. The deal here calls for Company B to bor-
row the money at a fixed rate of 9.5 percent. The swap dealer agrees to cover the fixed
loan payments, and the company agrees to make floating-rate payments to the swap
dealer at a rate of prime plus, say, 1.5 percent. In this second arrangement, the swap
dealer is making fixed-rate payments and receiving floating-rate payments.
What’s the net effect of these machinations? First, Company A gets a fixed-rate loan
at a rate of 9.75 percent, which is cheaper than the 10 percent rate it can obtain on its
own. Second, Company B gets a floating-rate loan at prime plus 1.5 instead of prime
plus 2. The swap benefits both companies.
The swap dealer also wins. When all the dust settles, the swap dealer receives (from
Company A) fixed-rate payments at a rate of 9.75 percent and makes fixed-rate pay-
ments (for Company B) at a rate of 9.5 percent. At the same time, it makes floating-rate
payments (for Company A) at a rate of prime plus 1 percent and receives floating-rate
payments at a rate of prime plus 1.5 percent (from Company B). Notice that the swap
dealer’s book is perfectly balanced, in terms of risk, and it has no exposure to interest
rate volatility.
Figure 23.10 illustrates the transactions in our interest rate swap. Notice that the
essence of the swap transactions is that one company swaps a fixed payment for a float-
ing payment, while the other exchanges a floating payment for a fixed one. The swap
dealer acts as an intermediary and profits from the spread between the rates it charges
and the rates it receives.
CONCEPT QUESTIONS
23.5a What is a swap contract? Describe three types.
23.5bDescribe the role of the swap dealer.
23.5c Explain the cash flows in Figure 23.10.CHAPTER 23 Risk Management: An Introduction to Financial Engineering 795