A firm can borrow at a floating rate of LIBOR

Question

A firm can borrow at a floating rate of LIBOR - 1% on short-term loans.It swaps its short-term payments so that it receives LIBOR + 1.5% and pays a fixed rate of 5%.If the notional principal is $25 million,what is the amount the firm pays under the swap?
A)$125,000
B)$31,250
C)$62,500
D)$93,750
E)$125,500

Quizplus · Accepted Answer

The firm's borrowing rate is LIBOR - 1%, and they are receiving payments at LIBOR + 1.5%, so the net rate they are paying is 2.5% (LIBOR + 1.5% - LIBOR + 1%).

On the other side of the swap, they are paying a fixed rate of 5%.

Therefore, the net cost to the firm is 5% - 2.5%, or 2.5% of the notional principal of $25 million.

2.5% of $25 million is $625,000. However, the swap involves an exchange of payments, so the actual amount the firm will pay under the swap is only half of that, or $312,500.

Therefore, the correct answer is C) $62,500.