CFM13240 - Understanding corporate finance: derivatives: swaps: example of a swap

FTSE100 Swap example

The bank may quote Fonzap plc a rate based on LIBOR. For example, the company might have to pay LIBOR plus 0.5%. Suppose that the swap is based on a notional amount of £5 million, payment is to be made quarterly, and 3-month LIBOR is 4.0% 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. (In practice the amount would probably be calculated by reference to the number of days.)

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 2.521% = £126,050.

In addition, to reflect a dividend yield of, say 0.313% in the quarter the bank would pay an additional £15,650 making a total of 141,700.

It is likely that the payment and counter-payment will be netted off, so that the bank pays the company a net amount of £85,450.

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 dividend yield for the quarter is 0.300%. In respect of the FTSE leg of the swap, the company will therefore have to pay the bank £5,000,000 x (1.311% -0.300%). Accordingly this is:

£5,000,000 x 1.011% = £50,550.

Assuming that 3-month LIBOR is now 4.6%, the company will also have to pay £5,000,000 x 5.1% x3/12 on the interest leg, £63,750, making a total payment to the bank of £114,300.

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

Note that in this example, as the percentage change in the FTSE index is settled quarterly, Fonzap Ltd is effectively reducing its FTSE investment at the end of a quarter where the index rises and increasing it when the index falls, resetting its notional investment at £5m worth of FTSE index. If, on the other hand, the change in the FTSE index is settled only on final maturity, the investment is maintained at the FTSE multiplied by £1,000 and so will increase if, as Fonzap Ltd, hopes, the index increases.