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Bank, owns a large block of NASDAQ stocks. Back Bay would like to diversify into NASDAQ
stocks, and simultaneously Capital Bank would like to diversify into S&P 500 stocks. The oldfashioned
way of achieving the desired objectives would be for each party to sell the stocks they do
not want and reinvest the proceeds in the stocks they do want. Such an approach is very expensive in
terms of commissions. A much cheaper alternative is for each party to keep its own portfolio intact,
and arrange between themselves an equity swap.
Exhibit 15.5 Equity swap.
The swap agreement might dictate the following terms. For every percentage point that the
NASDAQ stock index rises over the course of the year, Capital Bank will pay Back Bay Investment
Management $1 million. Simultaneously, for every percentage point that the S&P 500 rises over the
course of the year, Back Bay will pay Capital Bank $1 million. Thus, if the NASDAQ index rises 15%
and the S&P 500 rises 11%, there will be a net payment of $4 million from Capital Bank to Back Bay.
If in the following year the NASDAQ index rises 23% and the S&P 500 rises 29%, Back Bay will pay
Capital Bank $6 million on net. The equity swap is illustrated in Exhibit 15.5.
In this equity swap, the notional principal is $100 million; that is, the payments equal a base of $100
million times the indexes‟ respective returns. The net effect of the swap is to essentially convert $100
million of Back Bay‟s Standard & Poor‟s stocks into $100 million of NASDAQ stocks.
Simultaneously, $100 million of Capital Bank‟s NASDAQ stocks will now perform as if they were
$100 million of Standard & Poor‟s 500 stocks. Both sides keep their assets parked where they were,
but they swap exposures on the notional principal.
Some arithmetic will prove the point that Back Bay‟s portfolio will now perform as if it were
invested in NASDAQ stocks instead of S&P stocks. If Back Bay did in fact own $100 million of
NASDAQ stocks, by the end of the first year, after the 15% rise in NASDAQ stocks, this portfolio
would have 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 of S&P stocks grows to $111 million after the 11%
S&P rise in the first year. The swap, however, 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. 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 vice versa for Capital
Bank. Total portfolio performance in subsequent years depends on how the swap proceeds are
reinvested by each party.
Exhibit 15.6 Interest rate swap.