On January 1, 2011, Cougar Company received a two-year $500,000 loan. The loan calls for payments to made at the end of each year based on the prevailing market rate at January 1 of each year. The interest rate at January 1, 2011, was 10 percent. Aggie company also has a two-year $500,000 loan, but Aggie's loan carries a fixed interest rate of 10 percent.
Cougar Company does not want to bear the risk that interest rates may increase in year two of the loan. Aggie Company believes that rates may decrease and they would prefer to have variable debt. So the two companies enter into an interest rate swap agreement whereby Aggie agrees to make Cougar's interest payment in 2012 and Cougar likewise agrees to make Aggie's interest payment in 2012. The two companies agree to make settlement payments, for the difference only, on December 31, 2012. If the interest rate on January 1, 2012 is 8 percent, what will be Cougar's settlement payment to/from Aggie?

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The interest rate swap allows Cougar to effectively have a fixed interest rate of 10% for the entire two-year period. Therefore, Cougar will pay Aggie the variable interest rate of 8% on the $500,000 loan, which amounts to $40,000 (8% x $500,000) for the interest payment in 2012. However, Cougar's fixed rate is 10%, so they would have paid $50,000 (10% x $500,000) in the absence of the swap. Therefore, Cougar will make a settlement payment to Aggie of $10,000 ($50,000 - $40,000).

On January 1, 2011, Cougar Company Received a Two-Year $500,000