Question

A year ago a bank entered into a $50 million five-year interest rate swap. It agreed to pay company A each year a fixed rate of 6% and to receive in return LIBOR. When the bank entered into this swap, LIBOR was 5%, but now interest rates have risen, so on a four-year interest rate swap the bank could expect to pay 6.5% and receive LIBOR.

(a) Is the swap showing a profit or loss to the bank? Explain.

(b) Suppose that at this point company A approaches the bank and asks to terminate the swap. If there are four annual payments still remaining, calculate how much should the bank charge A to terminate?

Answer 1

A) The terms of the deal are

1) Total Swap agreement vaule = $50 mn

2) Bank pays a fixed rate of 6% to company A

3) Company A pays a variable rate of LIBOR to the bank

There in such an agreement, with the new reality, the Libor is at 6.5% for 4 years

Hence the spread for the bank is 0.5% on $50 mn = Profit of $250,000

B) The bank will charge the company A, either $250,000 which was the profit deemed due to the bank or it could charge the present value of $250,000