Question

The Bank of Moronto has negotiated a plain vanilla swap in which it will exchange fixed payments of 10 percent for floating payments equal to LIBOR plus 0.5 percent at the end of each of the next three years. In the first year, LIBOR is 8 percent; in the second year, 9 percent; in the third year, LIBOR is 7 percent. What is the total net payment the Bank of Moronto makes over the three-year period if the notional principal is $10 million?

Answer 1

According to the swap,

Bank of Moronto pays 10% and receives LIBOR + 0.5%

Hence,

At the end of year 1 - Pays 10% & Receives - ( 8 + 0.5)% = 10-8.5 = 1.5%

Net Payment = 1.5 %

At the end of year 2 - Pays 10% & Receives - ( 9 + 0.5)% = 10-8.5 = 0.5%

Net Payment = 0.5 %

At the end of year 3 - Pays 10% & Receives - ( 7 + 0.5)% = 10-7.5 = 2.5%

Net Payment = 2.5 %

Total Payment = Total Basis * Notional Amount

= ( 1.5 + 0.5 + 2.5)% * 10 * 10^6

= 4.5% * 10 * 10^6

= $450,000

Hence, Total Payment over 3 years = $450,000