The Bank of Moronto has negotiated a plain vanilla swap whereby it will exchange fixed payments of 10 percent for floating payments equal to LIBOR plus 0.5 percent at the end of each of the nextthree years. In the first year, LIBOR is 8 percent; in the second year, 9 percent; in the third year, LIBOR is 7 percent. What is the total net payment the Bank of Moronto makes over the three-year period if the notional principal is $10 million?

Question

Quizplus · Accepted Answer

Year 1:
Fixed payment = 10% x $10 million = $1 million
Floating payment = LIBOR + 0.5% = 8% + 0.5% = 8.5%
Net payment in year 1 = $1 million - $850,000 = $150,000

Year 2:
Fixed payment = 10% x $10 million = $1 million
Floating payment = LIBOR + 0.5% = 9% + 0.5% = 9.5%
Net payment in year 2 = $1 million - $950,000 = $50,000

Year 3:
Fixed payment = 10% x $10 million = $1 million
Floating payment = LIBOR + 0.5% = 7% + 0.5% = 7.5%
Net payment in year 3 = $1 million - $750,000 = $250,000

Total net payment over three years = $150,000 + $50,000 + $250,000 = $450,000 negative (or -$450,000) because the Bank of Moronto pays more in fixed payments than it receives in floating payments over the three-year period. Therefore, the answer is (D).

The Bank of Moronto Has Negotiated a Plain Vanilla Swap