The Portable MBA in Finance and Accounting, 3rd Edition

Financial Management of Risks 449

grown to be worth $115 million. But Back Bay owns $100 million of S&P
stocks, and has a position in an equity swap. The $100 million ofS&P stocks
grows to $111 million after the 11% S&P rise in the first year. The swap, how-
ever, pays Back Bay $4 million at the end of the first year. Thus, at the end of
the first year, Back Bay does have $115 million in total portfolio value. Verify,
that the total value of Capital Bank’s portfolio at the end of the first year will
be $111 million, just as if it had invested $100 million in S&P stocks.
Since the notional principal remains fixed at $100 million, the swap will
continue to convert $100 million of Back Bay’s S&P stocks into $100 million of
NASDAQ stocks, and visa versa for Capital Bank. Total portfolio performance
in subsequent years depends on how the swap proceeds are reinvested by
each party.

Interest Rate Swaps

The most common type of swap is an interest rate swap. The typical, or “plain-
vanilla” interest rate swap, is a “fixed for f loating swap,” whereby cash f lows
depend on the movement of variable interest rates. For example, consider two
firms Michel /Shaked Manufacturing (M) and Healing Heart Hospital (H). The
swap agreement might specify that M pay H a fixed 10% per year on a notional
principal of $100 million, and H pays to M the prime rate, as quoted in the
Wall Street Journal,times $100 million. Settlement might be once per year.
The prime rate quoted at the beginning of each year will determine the cash
f low paid at the end. Thus, if at first the prime rate is 12%, H will pay M $2
million at the end of the first year. If by the end of the first year the prime rate
has fallen to 7%, at the end of the second year M will pay H $3 million. And so
the swap continues for a specified number of years. H will benefit if rates fall;
M will benefit if rates rise. This interest rate swap is depicted in Exhibit 13.6.

Examples of Hedging Interest Rate
Exposure with a Swap

The Keating Computer Company assembles and markets computer hardware
systems. In the past several years Keating Computer has been one of the fastest

EXHIBIT 13.6 An interest rate swap.

Back Bay

Investment

Management

Capital Bank

Variable interest rate ×

$100 million

Fixed 10% interest rate ×

$100 million