Question

1. Assume that Caterpillar’s return on investments is 2.50% per annum for the next four years. Next, suppose that Caterpillar and UBS (a financial institution) enter the following four year interest rate swap: Catepillar pays X% per annum fixed to UBS and receives LIBOR from UBS. All payments are made annually. Catepillar’s net return after it enters the swap is (LIBOR + 0.75%) per annum. In this case, Catepillar transforms ___________ into __________ and X equals to ________.

1. Floating Rate Investment; Fixed Rate Investment;   1.75%
2. Fixed Rate Investment; Floating Rate Investment; 3.25%
3. Floating Rate Liability; Fixed Rate Liability; 3.25%
4. Fixed Rate Investment; Floating Rate Investment; 3.50%
5. Fixed Rate Investment; Floating Rate Investment; 1.75%

Answer 1

Since Catepillar gives away fixed rate and recieved LIBOR, he is transforming a fixed rate in to a floating rate investment.

Given that the net return is LIBOR + 0.75%, and UBS is only paying LIBOR, means that the another 0.75% is gained in the X% rate that is given to UBS.

Return on investment is 2.5% and since out of this 0.75% is saved, the give away would be (2.5% - 0.75%) = 1.75%

To summarise : Caterpillar earns 2.5%, gives a fixed rate of 1.75% to UBS and receives floating rate of LIBOR from UBS. Leading to a net gain of LIBOR + 0.75%

OPTION E summarises this theory.