New Developments in Financial Management
Swaps: A Zero Sum Game?
Stuart M. Turnbull
Stuart M. Turnhull is Associate Professor of Economics and Finance,
University of Toronto. He is also an Associate of the Institute for
Policy Analysis and the Faculty of Management Studies.
In the last decade there has been a dramatic increase
in the number of derivative securities, such as options
and futures, traded on organized exchanges. In a world
characterized by volatile interest rates, the limitation
of existing techniques to cope with such risk has result-
ed in the development of new products, such as futures
and options written on short- and long-term interest
rates, and financial swaps. Financial swaps differ from
futures and options in tnany important ways. In par-
ticular they are not necessarily standardized contracts:
parties In a financial swap can design their own con-
tract, which may extend over a period of many years.
The maturity of a swap contract is usually far greater
than the maturities of traded options and futures.
An interest rate swap in its basic form occurs when a
firm that has issued one type of debt instrument agrees
to swap interest payments with a firm that has issued
The comments ol D. Alexander. L. Booth. P. Halpem. }. Pesando and
L. Wakeman. an unknown referee and the editor are gratefully ai. knou I-
edged. Responsibility for any erTors remains with the author. This
research was supported hy a grant from the Financial Research Founda-
tion of Canada.
15
another type of debt instrument. For example, a firm
that may have issued fixed debt agrees in a swap to
make floating rate payments to a firm that issued float-
ing rate debt. In retum. this firm agrees to make fixed
rate payments to the other firm. Another example
would be the swapping of two different types of fioat-
ing rate debt. In a swap, coupon payments but not the
principal are swapped. Payments are conditional, in
that if one party defaults, the other is released from its
obligation.
It is claimed that the importance of the financial
swap arises because it allows a given borrower to ob-
tain funds with a particular maturity characteristic on
terms that are better relative to a benchmark in one
market than in another.' Bicksler and Chen | 3 | ascribe
the existence of financial swaps to the presence of
capital market imperfections and comparative advan-
tages among different borrowers in these markets.
They argue that differential information and institu-
'This is the rationale expressed in nearly every article on swaps. Sec. for
example. Gray el al. |4| and Lipsky and Elhalaski (5].
16
tional restrictions are major factors that contribute to
differences in transaction costs in the different mar-
kets. The argument that differential information gener-
ates the opportunity for financial arbitrage does not
provide an explanation for the rapid growth in the use
of financial swaps. Many institutions operate in the
domestic and Euro-markets. Thus, if the opportunity
for financial arbitrage arose, it would be quickly traded
away. Bicksler and Chen also observe that for two
firms of different credit risk the spread due to credit
differences is greater in the fixed term market than in
the fioating rate market. They rea.son that this differ-
ence in quality spreads presents a market arbitrage
opportunity and is the raison d'etre for interest rate
swaps. It will be shown that a difference in quality
spreads per se does not provide an explanation tor the
existence of interest rate swaps.
Smith et al. [7] identify four possible explanations
for the cost savings of swaps: financial arbitrage, tax
and regulatory arbitrage, exposure management, and
completing markets. Financial arbitrage, which would
exist in the type of world described by Bicksler and
Chen [3], is dismissed as a long run explanation, as the
very process of exploiting the opportunity would
eliminate it. Tax and regulatory arbitrage involves
some firms being able to utilize particular tax advan-
tages available in different countries. Unlike the case
of financial arbitrage, tax arbitrage will not disappear
unless there is a change in the tax code.- For regulatory
arbitrage, while it is correct to argue that disclosure
requirements are less in Euro-markets than those re-
quired in U.S. capital markets, it is not clear that this
gives rise to arbitrage opportunities. When pricing
bonds, investors would presumably take due note of
the lack of full disclosure of information.
For a firm concerned about risk or exposure man-
agement, swaps may allow it to undertake such man-
agement at a lower cost than that associated with using
existing instruments, such as options and futures. A
fourth and distinct issue is that swaps may complete
the market. That is. swaps provide a financial instru-
ment that cannot be duplicated by existing instru-
ments. For example, many swaps extend over a three-
to-five-year period. Such swaps cannot be duplicated
by existing traded options and futures, whose maturi-
ties are usually less than a year.
The purpose of this study is to examine the condi-
tions under which both parties to a swap benefit. In
Section I the traditional justification for an interest rate
swap is demonstrated via a textbook example. This
'The tax argument refers primarily to currency swaps.
FINANCIAL MANAGEMENT/SPRING 1987
Exhibit 1. Interest Rate Swap: Initial Situation
Rate
Firm A Firm B Differential
Fixed 10.75% 11.70'7f 95bps
Floating LIBOR + 25bps LIBOR+ 37i/2bps l2'/:bps
Net differential 82i/2bps
Step One
Firm A issues fixed at 10.75'?.
Firm B issues floating at LIBOR + 37'/2bps.
example is generalized in Section II and a number of
special cases considered. Conclusions are given in
Section III.
I. The Basic Interest Rate Swap
Firm A can issue U.S. dollar denominated fixed
debt at 10.75% or it can issue floating rate debt at
LIBOR + 25 basis points (bps).' Firm B. which has a
lower credit rating than firm A. can issue fixed rate
debt of the same maturity at 11.70% or floating rate
debt at LIBOR -H 37'/: bps. It would like to issue fixed
debt but with a lower coupon. Firm A would prefer to
issue floating debt, given the nature of its asset portfo-
lio. The details are summarized in Exhibit 1. Note that
the difference in the risk premiums in the fixed term
market is 95 basis points and in the floating rate it is
12'/2 bps. The differential in the fixed term market is
typically greater than that in the floating rate market.
The net differential is 82'/2 bps: this net differential
supposedly represents the gain from the swap that is
divided among the swap participants.
A financial intermediary facilitates a swap between
the two firms.'' Firm A issues fixed debt at 10.75Vf and
firm B issues fioating rate debt at LIBOR + 37'/2 bps.
In the swap, firm A agrees to pay the financial interme-
diary a floating rate of LIBOR -I- 15 bps and the
financial intermediary pays A a fixed rate of 1 \'7c r''
Firm B agrees to pay the financial intermediary a fixed
rate of 11.10% and the financial intermediary pays B a
'This example, which has been slightly modified, is taken from Arnold
"A financial intermediary is not necessary. Many financial intermediar-
ies act as the second firm and will warehouse the swap until they can off-
load it.
'To avoid complication, il is assumed that all payments are made at the
same time. While it is a straight forward exercise to relax this assump-
tion, no additional insights are generated.
"In practice these payments would be netted.
TURNBULL/SWAPS: A ZERO SUM GAME? 17

Exhibit 2. Example of Interest Rate Swap

Financial
Intermediary

Floating Floating Fixed

LIBOR +. 15bps LIBOR + 10bps ll.lO'-i

Finn B

Issues Fixed at 10.75'7f Issues Floating at

LIBOR + 37i/2bps

Net Payments
Firm A Firm B
Pays 10.75% LIBOR -I- 37'/2bps
LIBOR + 15bps 11.10%
(to financial intermediary) (to financial intermediary!
Receives 117( LIBOR + 10bps
(frotn financial intennediaty) (from financial intermediary)
Net Payment LIBOR - 10 bps.

floating rate of LIBOR -I- 10 bps. The net payments to be misleading if financial instruments differ in design
the two companies are shown in Exhibit 2. Firm A has and risk.
issued fixed debt at 10.75% and has agreed to pay the
financial intermediary LIBOR + 15 bps. It receives II. General Analysis
from the financial intermediary a fixed rate payment of To determine the conditions under which the differ-
11 %. Thus its net payment is a floating rate of LIBOR ent parties to a swap benefit, it is necessary to deter-
- 10 bps. Firm B has issued floating debt at LIBOR mine the present value of the different cash fiows to
-I- 37'/2 bps and has agreed to pay the financial inter- each party. The example given in Section I will be
mediary 11.10%. It receives from the financial inter- generalized. As a swap is driven by relative interest
mediary a fioating rate payment of LIBOR -I- 10 bps. rate differentials, the details for finii A are left un-
Thus its net payment is a fixed rate of 11.375%. changed. It is assumed that the firm of lower credit
The result of the swap is that firm A has effectively rating, firm B, can i.s.sue fixed rate debt at 10.75%
issued floating rate debt at LIBOR - 10 bps and firm -I- A and fioating rate debt at LIBOR + 25 bps -I- A,,
B has effectively issued fixed rate debt at 11.3757(. If where the risk premiums A and A, are positive. See Ex-
firm A issued floating rate debt directly it would be at hibit 3.
the rate of LIBOR -I- 25 bps. Thus via the swap it
saves 35 bps. Firm B has effectively issued fixed rate Exhibit 3 . General Form of Interest Rate Swap: Ini-
debt at 11.375'/(. If it issued fixed rate debt directly, it tial Situation
would be at the rate of 11.70%. Thus via the swap it Rate
saves 32'/2 bps. The financial intermediary gains 10 Differen-
Firm A Firm B tial
bps on the fixed part of the swap and 5 bps on the
fioating part. Total benefits to all parties sum to 82/2 Fixed 10.75'/, A
bps ( = 3 5 - 1 - 32'/2 -I- 15). and thus it appears that Floating LIBOR-h 25bps LIBOR + 25bps-HA, A,
everyone benefits by the swap. This is the conclusion Net differential \ \
drawn by most articles describing swaps. It is argued
Step One
in the next .section that this conclusion is not necessar- Firm A issues fixed at 10.75';',.
ily correct. A simple comparison of interest rates can Firm B issues floating at LIBOR -1- 25bps + A,
18 FINANCIAL MANAGEMENT/SPRING 1987

Exhibit 4. General Form of Interest Rate Swap

Financial \
Intermediary
/ ^ \

\
Floating -^ Fixed - ^ Floating ^ Fixed
LIBOR + 25bps 10.75% + A| LIBOR + 25bps - B, 10.75% + B

Firm A Firm B

i
Issues Fixed at
J,
Issues Floating at
10.75% LIBOR + 25 bps + A,

Financial Intermediary
Firm A (FI) Firm B
Pays 10.75% 10.75% + A| LIBOR + 25bps -^ A,
LIBOR -t- 25bps - A LIBOR + 25bps - B, 10.75% + B
deceives 10 75% + A, LIBOR + 25bps -- A LIBOR + 25bps - B,
10.75% + B
Net Payment LIBOR + 25bps - (A + A|) -KB -1- B,) - (A -h A|)l 10.75% + A, + (B 4 B,)

In the swap, firm A agrees to pay the financial
intermediary a floating rate of LIBOR + 25 bps - A
and the financial intermediary pays A a fixed rate of
10.75% + A,. Firm B agrees to pay the financial
intermediary a fixed rate of 10.75% + B and the
financial intermediary pays B a floating rate of LIBOR
+ 25 bps - B|. The details are shown in Exhibit 4.
In the traditional way of evaluating swaps, firm A is
paying a floating rate of LIBOR + 25 bps - (A + A,)
via the swap. If it issued floating rate debt directly, it
would be at the rate of LIBOR + 25 bps. Thus, it is
"better o f f if
A + A, >0.
Firm B is effectively paying a rate fixed at 10.75% +
Af + (B + B|). compared to 10.75% + A if it issued
fixed rate debt directly. Thus the swap is advantageous
to firm B if
B B, <A - A,
implying that the credit differential in the fixed rate
market must be greater than that in the floating rate
market. The financial intermediary receives payments
of (LIBOR + 25 bps - A) and (10.75% + B) and is
committed to making payments of (10.75% + A,) and
(LIBOR + 25 bps - B,). Thus the financial interme-
diary will "benefit" by the swap if
B B, > A (3)
This can be written in the following form:
B - A, > A - B,.
If the spread to the financial intermediary on the fixed
rate component of the swap (B - A,) is greater than
the spread on the fioating rate component (A - B,).
then the swap is "beneficial."
Thus in the traditional analysis, all parties will bene-
(1) fit if, combining (I), (2) and (3),
0 < A -I- A, < B + B, <A - A,. (4)
This type of analysis underlies that typically found in
most articles describing the merits of swaps.' It will
now be shown that while (4) is a necessary condition, it
(2)
is not a sufficient condition.
For firm A the cost of participating in the swap is
'See for example. Arnold | l ] . Price ei al. |61, and Beldleman | 2 |
(Chapter 13).
TURNBULL/SWAPS: A ZERO SUM GAME?
PVjSwap) = PV.,(10.75VO + PV,(LIBOR -^
25 bps - A) - PVp,(10.75'7r + A,) + TC,.
where PV^(10.757() is the present value of issuing
debt at 10.75%; PVJLIBOR -I- 25 bps - A) is the
present value of the floating rate coupon payments it
promises to pay the financial intermediary; PVp,
(10.75'/( + A|) is the present value of the fixed rate
coupon payments that the financial intermediary prom-
ises to pay firm A; and TC^ is the after-tax transaction
costs generated by participating in the swap.
For the swap to be of benefit to firm A, it must be
that the cost of participating in the swap is less than the
cost of issuing floating rate debt directly. In making
such a comparison, it is necessary to compare apples
with apples. In the swap, while firm A may have
issued callable fixed rate debt, the swap is defined over
the maturity of the debt and presumably this effectively
nullifies the option associated with callability. Thus
the appropriate instrument for comparison in the swap
is the cost to firm A of issuing non-callable floating
rate debt. Hence the swap will be of benefit to firm A if
PVjSwap) <PV,( LIBOR + 25 bps) -I- TC;,
where PV^(LIBOR + 25 bps) is the present value of
issuing non-callable floating rate debt; and TC\ is the
after-tax transaction cost of issuing such debt. Com-
bining the two preceding expressions gives
PV^(10.75'7r) + PV,(LIBOR + 25 bps - A) -
PVp,(10.75'7f + A,) -I- TC^ < PV,,(L1BOR +
25 bps) + TC;. (5)
For firm B the cost of participating in the swap is
= PVB(LIBOR + 25 bps + A,) + If the bond markets for fixed and floating rate debt
.757r + B) - P
25 bps - B,) +
where PV[,(LIBOR ^ 25 bps + A,) is the present
value of issuing floating rate debt at the rate LIBOR +
25 bps -I- A,;PVB(10.75'7f + B) is the present value of
the fixed coupon payments to the financial interme-
diary; PVp,(LIBOR + 25 bps - B,) is the present
value of the floating rate coupon payments the finan-
cial intermediary promises to pay firm B; and TCj, is
the after-tax transaction costs generated by participat-
ing in the swap.
For the swap to be of benefit to firm B, it must be
that the cost of participating in the swap is less than the
cost of issuing flxed rate debt directly. Given the con-
19
tractual nature of the swap, the appropriate comparison
is the cost to firm B of issuing fixed rate non-callable
debt. Thus the swap will be beneficial if
PV^CSwap) < PVB( 10.759^ + 1) + TC^.
where PVg( 10.75^/f -I- A) is the present value of issu-
ing fixed rate non-callable debt; and TCg is the after-
tax transaction cost associated with issuing such debt.
Combining the two preceding expressions gives
PVB(LIBOR -I- 25 bps + A,) -I- P\/f,i\0J5'/i + B)
- PV,,(LIBOR + 25 bps - B,) + TC^ <
+ 1) + TC;. (6)
For the swap to be beneficial to the financial inter-
mediary, the present value of its inflows must not be
less than the present value of the outflows:
PV,(LIBOR -I- 25 bps - A) + PVB( 10.75% + B)
> PVp,(10.75% + A,) + PVp,(LlBOR +
25 bps - B|).
Strict equality will hold if the market for acting as a
financial intermediary is competitive. The preceding
expression can be written in the form.
PV^(L1BOR + 25 bps - A) + PVB(10.75'7f + B)
= PVp,(10.757f + A,) + PV,,(LIBOR +
25 bps - B,) + PV. (7)
where PV is the present value of any economic profits
to the financial intermediary, and is non-negative. For
all parties to the swap to benefit, then conditions (5).
(6), and (7) must hold.
A. Proposition
are competitive, then a swap must be a zero sum game.
B. Proof
The logic behind the proof is very simple. A swap
results in a shifting of risk among the different parties.
Unless there are externalities, not everyone can gain
from this shifting of risk.
For A to benefit by the swap then, assuming transac-
tions costs are zero, from (5):
PV,,(L1BOR -I- 25 bps) - PV,(1O.75%) >
PV^(LIBOR + 25 bps - A) -
PVp|( 10.75% + A,). (8)
Substituting (7) into (8) gives
20
PV,(LIBOR + 25 bps) - PV,| 10.757,) >
PV|,(LIBOR + 25 bps - B,) -
PVB(10.757r + B) -I- PV, (9)
and from (6), which is a condition for firm B to benefit
by the swap, then (9) can be written
PV,(LIBOR + 25 bps) - PV,(I0.759;:
P V B ( L I B O R + 25 bps + A,) -
PVp(10.75'X + 1) + PV. (10)
Equation (10) implies a contradiction to the assump-
tion that bond markets are competitive. Firm A can
issue either fixed rate debt at 10.759, or floating rate
debt at LIBOR + 25. Given that the firm is raising a
fixed amount of capital, then the present value of the
alternatives should be the same if the bond markets are
competitive, otherwise the firm would always prefer
the debt source with the lowest present value. Similar-
ly for firm B. it can issue either fixed rate debt at
10.757, + A or floating rate debt at LIBOR + 25 bps
+ A|. and the present value of the two alternatives
should be the same.
The proposition is still valid if PV = 0. QED.
In a swap there is a shifting of risk. The preceding
result simply states that unless there are externalities
not everyone can gain. It should be noted that contrary
to common assertion, this result holds even though
there exists a difference in the credit differential be-
tween fixed and floating rates.
C. Corollary
In a competitive market, there is no reason why the
differential in floating rates. A,, between firm A and B
should equal the differential in fixed rates. A.
D. Proof
In a competitive market, the present value of issuing
either fixed or floating rate debt for firm A must be the
same:
PVJLIBOR -I- 25 bps) = PV^( 10.75%). ( I D
Similarly for firm B
P V B ( L I B O R + 25 bps + A,) = case, externalities must exist. What are these exter-
PVB(10.75'7f -I- A). (12)
Thus,
P V B ( L I B O R + 25 bps + A,) - PV^(LIBOR +
25 bps) = P V B ( 1 0 . 7 5 % -t- A) - PV,( 10.7570.
FINANCIAL MANAGEAAENT/SPRING 1987
Present value depends upon the covariance of the cash
flows with the marginal rate of substitution of con-
sumption. Given that the probability distributions of
the two firms differ, then in general A, and A are not
equal.' QED.
The traditional interest rate differential analysis as
represented by Equation (4) is deficient. It is not a
sufficient condition to indicate that a swap is benefi-
cial. A corporate treasurer, not to mention many in-
vestment bankers, might dispute such a statement. The
above corollary shows that, in general, an interest rate
differential will exist between fixed and floating rates
for firms of different credit risk even in an efficient and
a competitive market. Unless there are externalities,
this cannot be the driving force behind swaps.
A sufficient condition for all parties to benefit by a
swap can be derived by combining (5), (6), and (7):
[PV^CLIBOR + 25 bps) - PV,( 10.757,)]
+ [ P V B ( 1 0 . 7 5 % + A) - P V B ( L I B O R + 25 bps
+ A,)| > PV + (TC, - TC;)
- TC;,). (13)
The terms inside the first square brackets on the left-
hand side of the inequality measure the dollar advan-
tage (if any) of firm A issuing fixed rate debt directly
compared to fioating rate debt. The terms inside the
second square brackets measure the dollar advantage
(if any) of firm B issuing fioating rate debt directly
compared to fixed rate debt. The first term on the right-
hand side measures the excess economic profits to the
financial intermediary, and the remaining terms mea-
sure the differential transaction costs.
III. Conclusions
Two conclusions follow from this work. First the
type of interest rate differential analysis commonly
used to demon.strate the benefits of a swap can be
misleading. The paper describes a general methodolo-
gy with which to analyze the possible benefits of a
swap in terms of present values. Second, if bond mar-
kets are competitive, not all parties to a swap can
benefit. If parties do benefit in a swap, and the tre-
mendous growth in swaps would suggest this is the
nalities.' Is one of the externalities that of incomplete
markets, as suggested by Smith et al. [7]? Future em-
"Any specific pricing model, such ;is ihc capital asset pricing mixlel. can
be used to verify the result.
TURNBULL/SWAPS: A ZERO SUM GAME? 21

pirical research hopefully will be able to answer this
question.
References
1. T. S. Arnold. "How to Do Interest Rate Swaps," Harvard
Business Review (September-October 1984). pp. 96-101.
2. C. R. Beidleman. Financial Swaps. Homewood. IL. Dow
Jones-lrwin. 1985.
.V J. Bicksler and A. H. Chen. "An Economic Analysis of
Interest Rate Swaps." Journal of Finance (July 1986). pp.
645-655.
R. W, Gray. W. C. F. Kurz. and C. N. Strupp. -Interest
Rate Swaps." in Swap financing Techniques edited by Boris
Antl. London. Euromoney Publications. 1983. pp. 11-15.
J. Lipsky and S. Elhala.ski. "Suap-Driven Primary Issuance
in the International Bond Market." Salomon Brothers Inc.
(January 1986).
J. A. .\1. Price. J. Keller, and M. Nelson. "The Delicate Art
of Swaps." Euromoney (April 1983). pp. 118-125.
C. W. Smith. Jr.. C. VV. Smithson. and L. M. Wakeman.
"The Evolving .Market for Swaps." Midland Corporate Fi-
nancial Journal (Winter 1986). pp. 20-32.

THIRD ANNUAL SYMPOSIUM

ON CASH, TREASURY AND WORKING CAPITAL MANAGEMENT
October 14. 1987
The Las Vegas Hilton
Las Vegas, Nevada
Papers are invited for presentation at the Third Annual Symposium on Cash. Treasury and Working Capital
Management. The Symposium will be held on October 14. 1987 in Las Vegas. Nevada, immediately before
the Financial Management Association annual meeting.
The Symposium is organized as a forum for exchange of research ideas for scholars active in all aspects of
working capital management. Papers examining state-of-the-art applications that provide insight into possi-
ble new avenues for research are also acceptable. Abstracts or completed papers should be submitted in
triplicate before June 1, 1987. A review committee consisting of active researchers in the area of working
capital management will screen submitted papers. At the author's request, accepted papers will be considered
for publication in Advance.^ in Workitig Capital Management, published by JAI Press Inc.
Abstracts and papers should be sent to:
Professor Yong H. Kim
College of Business Administration
University of Cincinnati
Cincinnati, OH 45231
(513)475-7070
or
Professor Benoit Deschamps
College of Business Administration
Georgia State University
Atlanta, GA 30303
(404) 658-2632
or
Professor Bemell K. Stone
School of Management
Brigham Young University
Provo, UT 84602
(801) 378-2295