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Interest Rate Swaps
The most common type of swap is an interest rate swap. The typical or plain-vanilla interest rate swap
is a “fixed for floating” swap, whereby cash flows depend on the movement of variable interest rates.
For example, consider two firms Crowninshield Manufacturing (C) and Healing Heart Hospital (H).
The swap agreement might specify that C pays H a fixed 10% per year on a notional principal of $100
million, and H pays to C the prime rate, as quoted in the Wall Street Journal, times $100 million.
Settlement might be once per year. The prime rate quoted at the beginning of each year will determine
the cash flow paid at the end. Thus, if at first the prime rate is 12%, H will pay C $2 million at the end
of the first year. If by the end of the first year the prime rate has fallen to 7%, at the end of the second
year C will pay H $3 million. And so the swap continues for a specified number of years. H will
benefit if rates fall; C will benefit if rates rise. This interest rate swap is depicted in Exhibit 15.6.
Examples of Hedging Interest Rate Exposure with a Swap
The Keating Computer Company assembles and markets computer hardware systems. In the past
several years Keating Computer has been one of the fastest-growing computer hardware companies. It
borrowed extensively to finance this growth. Currently on the books is a very large long-term
variable-rate loan. Also on the books is a sizable amount of short-term debt. The managers of Keating
Computer have observed that they are dangerously exposed to interest rate risk. If rates should rise,
they will have to pay more in debt service on the variable-rate loan, and they will face higher interest
rates when they roll over their short-term debt. The company is currently profitable, but they worry
that rising interest rates can wipe out that profit. Since the company is planning an equity offering in
coming years, management is very concerned about the prospect of reporting any losses over the near
term.
One solution to Keating Computer‟s problem would be to refinance at fixed interest rates. The
transaction costs of refinancing, however, are sizable, and the rates currently offered on long-term
debt are not favorable. Entering an interest rate swap is a better hedging strategy. The company should
enter as the fixed rate payer, which means it would be the variable rate receiver. As interest rates rise,
the company will make money on the swap, offsetting the higher payments it must make on its own
debt. Since swaps are over-the-counter instruments, the company can tailor the terms of the swap so
that the hedge will be in force for the exact number of years needed. Moreover, the notional principal