Question

Schifano Motors of Italy recently took out a 4-year €5 million loan on a floating rate basis. It is now worried, however, about rising interest costs. Although it had initially believed interest rates in the Eurozone would be trending downward when taking out the loan, recent economic indicators show growing inflationary pressures. Analysts are predicting that the European Central Bank will slow monetary growth driving interest rates up. Schifano is now considering whether to seek some protection against a rise in euro-LIBOR, and is considering interest swap strategies. LIBOR is currently 6.50% and would rise at the rate of 50 basis points per annum, starting tomorrow. Schifano has just made the first interest payment today, so the next payment is due 1 year from today. Schifano finds that she can swap her current floating rate payments for fixed payments of 7.00% per annum. What interest swap strategy should Schifano use? Calculate how much Schifano save by making the correct swap?

Answer 1

Schifano's loan is floating and it may increase 50 basis point per year

so vanilla swap can be used to hedge risks against interest rate

in this swap the rate of interest is same fixed for the buyer

Consider swp from 2nd year

If LIBOR rate increase 0.50 point basis per year . here Floating rates are -

2nd year 6.50 + 0.50 = 7.00 %

3rd year 7.00 +0.50 = 7.50 %

4th year 7.50 + 0.50 = 8.00 %

Calculation of savings of interest - ( swap fixed rate = 7 %)

Year	2	3	4
floating interest	7%	7.50%	8%
fixed interest	7%	7%	7%
Change in price for floating	5000000* 7% = 350000	5000000*7.50% = 375000	5000000*8.0% = 400000
price for fixed	5000000* 7% = 350000	350000	350000
Floating- Fixed Interest	0	25000	50000
Total Savings	75000
(sum of the three year savings)

Total savings is 75000 Euro

Please note the Re-payment details and swap premium aren't provided

so the consideration is made for 5 million euro