Question

If a company that had a fixed-rate liability wanted to achieve a floating-rate cost of funds through a swap, it would pay a: A. fixed rate to the counterparty and receive a floating rate in return from the counterparty. B. floating rate to the counterparty and pay a floating rate to the fixed-rate lender. C. floating rate to the counterparty and pay a fixed rate to the fixed-rate lender. D. floating rate to the counterparty and receive a fixed rate in return from the counterparty.

why the answer is c

Answer 1

the counterparty that wants to swap its floating-rate payments and receive fixed-rate payments is called a receiver or seller. The counterparty that wants to swap its fixed-rate payments is the payer.

The counterparties make payments on loans or bonds of the same size. This is called the notional principle. In a swap, they only exchange interest payments, not the bond itself.

Also, the present value of the two payment streams must also be the same. That means that over the length of the bond, each counterparty will pay the same amount. It’s easy to calculate the NPV for the fixed-rate bond because the payment is always the same. It's more difficult to predict with the floating rate bond. The payment stream is based on Libor, which can change.

Based on what they know today, both parties have to agree then on what they think will probably happen with interest rates.

A typical swap contract lasts for one to 15 years. It's called the tenor. The counterparty can terminate the contract earlier if interest rates go haywire. But they rarely do in real life.