Question

1) Company A and a bank enter a three-year, plain-vanilla interest rate swap. Company A has floating rate debt based off LIBOR while the bank pays a fixed rate debt.    Company A agrees to exchange the LIBOR rate for a 10% fixed rate on $10 million notional amount. LIBOR is currently at 11%.     A year later, LIBOR increases to 12%.  

Question:

a) Calculate the payments for company A and the bank at end of one year.   Which party will receive the net payment?  

B) What’s the advantage for company A to receive fixed payment?          

Answer 1

In simple interest rate swap the Company A which has a floating interest of LIBOR agrees to exchange it with Bank at a fixed rate for a 10% on $10 million notional amount.

Now, the only amount that would be paid is the interest part. In this case Company A will pay 10% interest to Bank and Bank will pay LIBOR to company at 11%. In this case only net payments would be made thus Bank will pay 1% to the Company A. (LIBOR increases to 12% after end of one year thus we will calculate LIBOR as 11%)

Now 1% of $10 million = $ 0.1 million or $100,000

Company A will receive the net payment

B. The Company A has advantage that the liability of interest is constant irrespsective of the market conditions.