Question

ABC Corporation currently has a fixed rate loan with an interest rate of 11% per year.  The company prefers to pay a floating interest rate for the next four years because it will be a better match for its liabilities. ZYX corporation has a floating rate loan at LIBOR plus 1.5% and prefers to pay a fixed rate for the next four years.. The companies meet and agree to an interest rate swap with a notional principal of $10,000,000.  Under the terms of the agreement, ABC pays ZYX LIBOR plus 1.25% with a 1 year reset while ZYX pays ABC a fixed rate of 10.75%. Assume annual interest payments.

a)   What is the floating rate ABC pays as a result of the swap?

      b)   What is the fixed rate ZYX pays as a result of the swap?

      c)   If the LIBOR rate is 9.5% the first year and 8.75% the second year, what are ABC’s dollar payments in these two years?

      d)   Who has the repricing risk and who has the credit risk before the swap is entered?

      e)   Does the notional principle change hands during the transaction?

      f)   Are the two companies’ original loans cancelled by the swap agreement?

Answer 1

a) .  Floating rate for ABC as a result of the swap = LIBOR plus 1.25%

b). Fixed rate for ZYX as a result of the swap = 10.75%

c). first year - LIBOR rate is 9.5% then LIBOR plus 1.25%

9.5% + 1.25% = 10.75%

$10,000,000 * .1075 = 1,075,000 - ABS dollar payment first year.

Second year - LIBOR rate is 8.75% then LIBOR plus 1.25%

8.75% + 1.25% = 10%

$10,000,000 * .10 = 1,00,000 - ABS dollar payment second year.

Total payments for year 1 an 2 for ABC = 2,075,000

d). XYZ corporation has the floating rate loan before the swap and has repricing risk because of the Libor reset.

XYZ and ABC corporation both has credit risk if borrower failed to make the promised payments.

e). Notional principle does not change hands during the transaction. Only in currency swap notional principal will change hands during the transaction.

f). Original loan did not cancelled by the swap agreement because of the cashflow mismatch occurs

For ABC,. ABC loan rate paid is 11% but swap rate received is 10.75%

For XYZ loan pays LIBOR plus 1.5% but receives from swap is LIBOR plus 1.25%.