Question

Burlingame Bank and the ABC Manufacturing Corp. enter into the following 7-year swap with a notional amount of $75 million and the following terms: Every year for the next seven years, Burlingame Bank agrees to pay ABC Manufacturing 7% per year and receive from ABC Manufacturing LIBOR.

a. What type of swap is this?

b. In the first year payments are to be exchanged, suppose that LIBOR is 4%. What is the amount of the payment that the two parties must make to each other?

Answer 1

a. This is an Interest Rate Swap where Burlingame Bank is a paying fixed interest rate of 7% per year to ABC Manufacturing and receive LIBOR which is a fluctuating rate of interest as per London Inter Bank Offered Rate.

b. In the first year payments,

N = Notional Amount = $75 million

r = 7%

RFluct = Fluctuating LIBOR Rate = 4%

Payments Made by Burlingame Bank:

7% of $75 million = $5.25 million

Payments Made by ABC Manufacturing:

LIBOR Rate 4% of $75 million = $3 million

Under Direct Method:

Swap Value = $5.25 - $3 million = $2.25 million

Under Discount Factor Method:

Discount Factor
Year 1	1/(1.07)^1	0.9346
Year 2	1/(1.07)^2	0.8734
Year 3	1/(1.07)^3	0.8163
Year 4	1/(1.07)^4	0.7629
Year 5	1/(1.07)^5	0.7130
Year 6	1/(1.07)^6	0.6663
Year 7	1/(1.07)^7	0.6227
Total		5.3893

Fixed Rate = c = 7 * (1-0.9345)/5.3893 = 0.085 or 8.5%
Swap Value = $6.375 (fixed rate) - $3 million(LIBOR) = $3.375 million