Understanding corporate finance: derivative contracts: swaps: example of a swap
The bank will quote Fonzap plc a rate based on LIBOR. For example, the company might have to pay LIBOR plus 0.1%. Suppose that the swap is based on a notional amount of £5 million, payment is to be made quarterly, and 3-month LIBOR is 4.4% at the beginning of the contract.
At the end of the first quarter, the company must pay the bank an amount equivalent to interest at 4.5% on a notional loan of £5 million, i.e.
£5,000,000 x 4.5% x 3/12 = £56,250.
The FTSE 100 leg of the swap is based on the same notional amount, £5 million. Suppose that the index stands at 5,950 at the start of the contract, and at the end of the first quarter it has risen to 6,100, an increase of 2.521%. The bank will pay the company
£5,000,000 x 2.52% = £126,050.
It is likely that the payment and counter-payment will be netted off, so that the bank pays the company a net amount of £69,800.
Suppose that, at the end of the second quarter, the FTSE 100 has fallen to 6,020, a fall of 1.311% over the quarter. The company will therefore have to pay the bank
£5,000,000 x 1.311% = £65,550.
Assuming that 3-month LIBOR remains at 4.4%, the company will also have to pay £56,250 on the interest leg, making a total payment to the bank of £121,800.
The bank is exposed to a credit risk. At the end of each quarter, Fonzap plc may receive a net payment from the bank, but equally it may have to make a payment. If there is a dramatic fall in the stock market, that payment could be large and the company might default. Thus, if it does not already have an established line of credit with the bank in question, the company may have to put up collateral.
The company is similarly exposed to a credit risk. It will not be significant where, as in this example, a company transacts a small-scale swap with an established bank or similar counterparty. However, it can become a factor when a major corporation, whose credit rating may be equal to or even better than that of the swap bank, transacts a very large swap.