Question

Consider a $30 million notional amount interest rate swap with a fixed rate of 7%, paid quarterly on a 90/360 day count convention. The first floating payment is set at 7.2%.

Calculate the first net payment and identify whether the party paying fixed or the party paying floating makes the payment.

Since one party knows in advance that they will be making a payment 90 from now (effectively a guaranteed loss at the 90-day mark, since swap contracts do not involve up front cash flows), why would they enter this swap contract?

(No Excel. Please show every step in detail)

Answer 1

Notional Principal Amount = $ 30 million

Fixed Rate = 7 % payable quarterly and Floating Rate = 7.2 % payable quarterly

Quarterly Fixed Rate Payment = 30 x 0.07 x (90/360) = $ 525000

Quarterly Floating Rate Payment = 30 x 0.072 x (90/360) = $ 540000

First Net Payment = 540000 - 525000 = $ 15000

The party paying the floating rate cash flow pays more and since cash flow payments are netted, the floating rate paying party is making the actual payment post netting.

Even though the fixed rate paying party knows how much it will pay, an off-balance sheet transaction like an interest rate swap is efficient at hedging against interest rate fluctuation risks. In other words, it allows the fixed rate paying party to continue paying the fixed rate even if existent current interest rates rise.