Question

Consider a Plain Vanilla Interest Rate Swap agreement that AAA pays a fixed rate of 3% per annum and BBB pays LIBOR rate at the end of year for 3 years on a notional principal of $100m. In return, AAA receives LIBOR rate per annum and BBB receives a fixed rate of 3%.

The LIBORs to be applied for cash flows are 2.8%, 3.3%, 3.5%.

PMT	LIBOR	Cash Flow (floating)	Cash Flow (Fixed)	Cash Flow (Net)
1	2.8%
2	3.3%
3	3.5%

Answer 1

Notional Principal = $100mn

Fixed rate = 3% ; Floating Rate = LIBOR

Year	PMT	LIBOR	Cash Flow (Floating)	Cash Flow (Fixed)	Cash Flow (Net AAA= Floating Cash Flow - Fixed Cash Flow)	Cash Flow (Net BBB= Floating Cash Flow - Fixed Cash Flow)
1	$ 10,00,00,000.00	2.80%	$ 28,00,000.00	$ 30,00,000.00	$ -2,00,000.00	$ 2,00,000.00
2	$ 10,00,00,000.00	3.30%	$ 33,00,000.00	$ 30,00,000.00	$ 3,00,000.00	$ -3,00,000.00
3	$ 10,00,00,000.00	3.50%	$ 35,00,000.00	$ 30,00,000.00	$ 5,00,000.00	$ -5,00,000.00

The PMT remains the same as the notional principal concept, under swap agreement the principal isn't paid off thus remains the same throughout the period.

The cash flows for the floating-rate are calculated as follows:

Cash Flows(Floating) = PMT * LIBOR(floating rate for the respective year)

The cash flows for the fixed-rate are calculated as follows:

Cash Flows(Floating) = PMT * 3%

So, as it can be seen from the table that the AAA only loses when the LIBOR rate falls below the fixed rate rest AAA gets positive cash flows as the LIBOR rates rises and going into the swap deal protects the AAA from the interest rate risk(interest rate volatitlity)