Understanding corporate finance: derivative contracts: swaps
In very general terms, a swap is a legally binding agreement to exchange a series of cashflows based on the value of, or return from, one property with a series of cashflows based on a second property. ‘Property’ can include an index, or some other measurable factor.
Fonzap plc is a cash-rich company which has spare cash invested in money market deposits paying a floating rate of interest. The finance director believes that a better return is to be had on the stock market, but does not have the resources to manage a share portfolio, and does not wish to have to pay Stamp Duty Reserve Tax and other transaction costs on direct dealings in shares.
It therefore arranges an equity index swap with its bank, based on the FTSE 100 index. The basis of the arrangement is:
- Fonzap Ltd makes payments to the bank each quarter (or at some other agreed interval) based on interest payable on a notional loan.
- The bank makes quarterly payments to Fonzap plc based on the percentage increase in the FTSE 100 index.
The arrangement can continue for a year, 2 years, 5 years or any other term agreed by the parties.
The diagram below illustrates the cashflows:
If the finance director is right, and the FTSE 100 outperforms the company’s money market investments, the company will make a profit. In effect, Fonzap plc has replicated the economic effect of taking its money out of interest-bearing investments and buying instead a portfolio of the shares that make up the FTSE 100.
We can say that the company has ‘swapped’ the return on money market deposits for the return on the FTSE 100 index. But it is important to note that Fonzap Ltd still retains the right to receive interest from its deposits. It has not assigned that right to the bank - it is merely making payments to the bank based on an interest rate. Indeed, the company could in theory enter into the swap even if it didn’t have the existing interest-bearing investments - although in the majority of cases companies will use a swap to hedge an asset or liability.
CFM13240 has more detail on this example.