A firm has entered into a 4-year, annual-pay, 6% plain vanilla interest rate swa

Question

A firm has entered into a 4-year, annual-pay, 6% plain vanilla interest rate swap with a notional principal value of $10,000,000. The firm is the fixed rate payer (i.e. the swap dealer is the floating rate payer) and the following spot rates are observed and expected over the next three years:

• 1-year LIBOR today = 5%.

• Expected 1-year LIBOR in a year = 6%.

•Expected 1-year LIBOR in two years = 7%.

Based solely on this information, what would be (1) the first net payment amount and (2) the direction (e.g. from the firm to the swap dealer or vice versa)?

Explanation / Answer

Payment is based on the 1 year LIBOR today

hence, floating will pay 5%*10000000=$500000

fixed will pay 6%*10000000=$600000

So, net payment will be from fixed to floating of 600000-500000=$100000

As firm will pay fixed so firm will pay $100000 to the swap dealer

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