Question

Schifano Motors of Italy recently took out a 4-year €5 million loan on a floating rate basis. It is now worried, however, about rising interest costs. Although it had initially believed interest rates in the Eurozone would be trending downward when taking out the loan, recent economic indicators show growing inflationary pressures. Analysts are predicting that the European Central Bank will slow monetary growth driving interest rates up. Schifano is now considering whether to seek some protection against a rise in euro-LIBOR, and is considering interest swap strategies. LIBOR is currently 6.50% and would rise at the rate of 50 basis points per annum, starting tomorrow. Schifano has just made the first interest payment today, so the next payment is due 1 year from today. Schifano finds that she can swap her current floating rate payments for fixed payments of 7.00% per annum.

What interest swap strategy should Schifano use? Calculate how much Schifano save by making the correct swap?

Answer 1

Upward sloping yield curve indicates the financial market expect higher interest rate in future, with floating interest rate Schifano Motors end up paying more interest rate then paid today, buy entering Swap interest rate interest paid yearly is fixed as determined by its particular market and parties involved.

by entering 7% per annum fixed interest rate swap Schifano motors will pay a fixed interest rate of 7% yearly irrespective of interest yield curve. below is 4 year Profit/loss assuming 6.5% current LIBOR and expected to increase 50 basis point (0.05%) per annum.

WithOut Swap Contract	Year 1	Year 2	Year 3	Year 4
Interest Paid	6.50%	7.00%	7.50%	8.00%
With Swap Contract	Year 1	Year 2	Year 3	Year 4
Interest Paid	6.50%	7.00%	7.00%	7.00%
Profit/Loss		0.00%	0.50%	1.00%