CFM13230 - Understanding corporate finance: derivatives: swaps

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.

The most commonly encountered swaps relate to interest rates (see CFM13320) and currencies (see CFM13420). However there can be other underling subject matter and the example below describes a swap whose underlying subject matter is a share index. As will be seen, the terms may be quite intricate.

Example

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. For example the rate might be GBP 3-month LIBOR plus 0.5%. Assume a notional principal amount of £10m.
  • The bank makes quarterly payments to Fonzap plc based on the percentage increase in the FTSE 100 index, plus the dividend yield. The amount of the FTSE index at inception will be such that its notional principal value is £5m. So if the FTSE index stands at 5,000 at inception, the payments will be based on the FTSE index multiplied by a figure that results in a total of £5m. Initially this will be £1,000, but the multiplier would reset at each quarter to maintain a notional principal amount of £5m.
  • It may be that the FTSE 100 falls in a quarter by more than the dividend yield. In that case the bank pays nothing to Fonzap Ltd, but Fonzap Ltd. will have to make an additional payment to the bank equal to the fall in the FTSE index, multiplied by £1,000, less the dividend yield.

The arrangement can continue for a year, 2 years, 5 years or any other term agreed by the parties.

The change in the FTSE index may not be settled quarterly, but instead settled on maturity. In that case Fonzap Ltd would make quarterly payments of £5m multiplied by LIBOR plus, say, 0.4%. On maturity, bank would pay Fonzap Ltd. the cumulative increase in FTSE index multiplied by £1,000 or Fonzap would pay bank cumulative decrease in FTSE index multiplied by £1,000. This type of settlement on maturity is probably more common, so long as the bank is satisfied with Fonzap Ltd’s credit risk or has security via margin payments (as for an exchange traded contract, see CFM13070).

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.

The reason a company might invest via an equity swap is that investing £5m in shares of each of the companies that make up the FTSE index may be impractical and could involve high transaction costs. It can be more efficient to enter into a derivative with a counterparty that transacts on a much bigger scale. A more common strategy, however, might be to invest in an ‘index-tracker’ fund that has underlying investments designed to track the FTSE index. Entering into the swap is economically similar to borrowing, at a floating rate in order to invest in the index.

CFM13240 has more detail on this example.