A company enters into an interest rate swap in order to hedge a $5,000,000 variable-rate loan.The loan is expected to be fully repaid this year on June 10.The contract requires that if the interest rate on April 30 of next year is greater than 11%,the company receives the difference on a principal amount of $5,000,000.Alternatively,if the interest rate is less than 11%,the company must pay the difference.Which of the following statements is correct regarding this contract?
A) The swap agreement effectively hedges the variable interest payments.
B) The timing of the swap payment matches the timing of the interest payments and,therefore,the variable interest payments are hedged.
C) The timing of the swap payment does not match the timing of the interest payments and,therefore,the variable interest payments are not hedged.
D) This swap represents a fair value hedge.

Question

Quizplus · Accepted Answer

The swap payment is based on the interest rate on April 30 of the next year, which does not align with the loan's expected full repayment by June 10 of this year. Therefore, the timing mismatch means the swap does not effectively hedge the variable interest payments.

A Company Enters into an Interest Rate Swap in Order