The debate is held over the swap. The answer is in the proportion of gross debt already fixed before anyone swapped anything, and in the cash on the other side.
The interest line has four numbers in it, and the smallest attracts more questions than the other three together: swap carry of 360,000.00 on a total interest charge of 26,547,500.00. It is paid because 180,000,000.00 of a floating term loan was swapped to 3.20 per cent fixed while the base rate sits at 3.00 per cent. The right question is not whether to pay it. It is what proportion of gross debt is fixed once the bonds are counted — 78.1818 per cent — and what is left floating once the group's own cash is netted against it, which is -608,000.00.
Worked in full in Treasury Management by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The accountant reads four instruments. The treasurer reads two exposures: what is fixed to maturity, and what reprices when the base rate moves.
| Line | Principal | Rate | Interest |
|---|---|---|---|
| Term loan, floating | 300,000,000.00 | 4.75 per cent | 14,250,000.00 |
| Bonds, fixed | 250,000,000.00 | 4.25 per cent | 10,625,000.00 |
| Revolver, undrawn | 250,000,000.00 | 0.525 per cent | 1,312,500.00 |
| Swap carry | 180,000,000.00 | 0.20 per cent | 360,000.00 |
| Total interest | 26,547,500.00 |
Raise the base rate by 200 basis points and hold everything else still. Unswapped, the whole term loan reprices; swapped, only the 120,000,000.00 that was left floating does.
| Unhedged | With the swap | |
|---|---|---|
| Interest before the shock | 26,187,500.00 | 26,547,500.00 |
| Extra interest at +200 basis points | 6,000,000.00 | 2,400,000.00 |
| Interest after the shock | 32,187,500.00 | 28,947,500.00 |
| Interest cover after the shock | 5.2194× | 5.8036× |
The shortcut in the middle row is wrong. Reading across 6,000,000.00 less 2,400,000.00 gives 3,600,000.00, and it measures from two baselines 360,000.00 apart. The swap saves the difference between the two totals after the shock: 32,187,500.00 less 28,947,500.00, which is 3,240,000.00. Divide that by the carry and the trade has a threshold: 9.0 years of carry buy one shock year, so the swap pays if a rise of 200 basis points held for a year arrives at least once in ten. How often it arrives is a view. It should be declared as one.
Cover reaches the covenant of 4.0000× when interest reaches 42,000,000.00. Unhedged, each 1 per cent on the base rate costs 3,000,000.00, and the covenant breaks at a base rate of 8.27 per cent. With the swap, each 1 per cent costs 1,200,000.00 and the covenant breaks at 15.88 per cent.
Both are far away, and that is the point: on this company leverage binds long before cover, so the cover covenant is not the reason for the swap. The reason is cash. Without the revolver the group clears its own minimum by 27,403,718.84, and unhedged the 6,000,000.00 of extra interest would take 21.8948 per cent of that margin before anything else did. A rate shock and a revenue shock are not obliged to arrive on separate days.
| Debt | Amount | Fixed | Floating |
|---|---|---|---|
| Bonds | 250,000,000.00 | 250,000,000.00 | 0.00 |
| Term loan, swapped | 180,000,000.00 | 180,000,000.00 | 0.00 |
| Term loan, unswapped | 120,000,000.00 | 0.00 | 120,000,000.00 |
| Gross debt | 550,000,000.00 | 430,000,000.00 | 120,000,000.00 |
Before the swap, the bonds alone made 45.4545 per cent of gross debt fixed. Swapping 60 per cent of the term loan sounds like a moderate hedge; the balance sheet it produces is 78.1818 per cent fixed, which is a decidedly fixed balance sheet. The first framing is the swap desk's and the second is the treasurer's. A policy written as “hedge 60 per cent of floating debt” will produce a different balance sheet every time the mix of bonds and loans changes, without anyone having decided that it should.
Cash earns floating too. Net floating exposure is the unswapped loan less the cash the treasurer can actually place: 120,000,000.00 less 120,608,000.00, which is -608,000.00. A negative figure means the group earns floating on slightly more than it pays floating on. The proportion that looked moderate on the loan and decidedly fixed on gross debt is, after cash, complete.
Three cautions belong on the same line as that figure. A deposit rate does not move one for one with the base rate, and a bank can widen the deposit spread while the loan margin is fixed by the facility. Cash is a balance on one morning; the loan is 300,000,000.00 every morning. And the cash is not all in the home currency: netting only home-currency balances leaves an exposure of at most 64,392,000.00. Print both, with the date they were computed on.
It will arrive with a chart of forward rates and a figure for the carry, and neither is the question. The question has three numbers in it. What proportion of gross debt is fixed, and what the policy says it should be. What the net floating exposure is after cash, and on which currencies. And what a 200 basis point rise costs in the year it arrives: 28,947,500.00 of interest as the balance sheet stands, 32,187,500.00 without the swap, 3,240,000.00 between them for 360,000.00 a year.
Neither, as an instrument. The decision is what proportion of gross debt is fixed and what the net floating exposure is after the company's own cash is netted against it. On the company in this book 78.1818 per cent of gross debt is fixed and the net floating exposure after cash is -608,000.00, so the balance sheet is effectively fully fixed.
Compare the interest bill after a rate shock with and without it, not the two increments. Here the shock leaves interest at 28,947,500.00 with the swap and 32,187,500.00 without, a saving of 3,240,000.00 against a carry of 360,000.00 a year — 9.0 years of carry for one shock year.
Floating debt less the cash the treasurer can actually place at a floating rate in the same currency. Here it is 120,000,000.00 of unswapped loan less 120,608,000.00 of available cash, which is -608,000.00; netting only home-currency balances it is at most 64,392,000.00.
This article is one calculation from Treasury Management. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: corporate finance, valuation and markets → · All 1706 articles →
If this book helped — or didn’t — a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.