Company A receives payments every six months of 3% on a principle amount of $5 million. It enters a swap with Company B. According to the swap, Company B will pay Company A a floating rate of LIBOR+.5% on a principle amount of $5 million and Company A will pay Company B a fixed rate of 3.5% on the same principle amount every six months. All payments (from the original asset and the swap) are paid and received on the same day. In total, what is the nature of Company A's asset?

Question

Company A receives payments every six months of 3% on a principle amount of $5 million. It enters a swap with Company B. According to the swap, Company B will pay Company A a floating rate of LIBOR+.5% on a principle amount of $5 million and Company A will pay Company B a fixed rate of 3.5% on the same principle amount every six months. All payments (from the original asset and the swap) are paid and received on the same day. In total, what is the nature of Company A's asset?

BlackTom AI · Accepted Answer

We start by restating the situation clearly to compare cash flows from the asset and from the swap.

Option analysis:

Option 1: 'Company A has a floating-rate asset.' 
- The asset itself pays a fixed coupon of 3% on the 5 million principal every six months. That is a fixed cash flow from the asset, not floating.
- However, Company A enters into a swap where it receives LIBOR + 0.5% (floating) from Company B and pays a fixed 3.5% on the same notional 5 million every six months.
- To determine the overall nature of Company A’s combined position (asset plus swap), we combine the asset cash flows with the swap cash flows.
- Asset cash flow: +3% of 5,000,000 every six months = +150,000 every six months (fixed).
- Swap cash flows: receive floating LIBOR + 0.5% and pay fixed 3.5%; net to A from the swap is (LIBOR + 0.5) − 3.5 = LIBOR − 3.0.
- Total cash flow to A = fixed 150,000 (from the asset) + [LIBOR − 3.0% of 5,000,000] (from the swap).
- Convert the fixed part: 3.0% of 5,000,000 = 150,000. So net from asset+swap is 150,000 + LIBOR×5,000,000 − 150,000 = LIBOR×5,000,000. 
- This simplifies to a payment that varies with LIBOR only, i.e., a floating-rate cash flow tied to LIBOR.
- Therefore, despite the asset itself being fixed, the combined position (asset plus swap) behaves as a floating-rate asset, because the fixed receipts and fixed payments cancel, leaving only the LIBOR component.

Option 2: 'Company A has a fixed-rate asset.'
- This would be true if the total cash flows from the asset and swap remained fixed. But as shown, the LIBOR component from the swap offsets the fixed components, leaving a LIBOR-linked payoff. Hence the overall position is not fixed-rate.

Why the other options are incorrect:
- The fixed coupon from the asset alone does not determine the nature of the overall position when a swap is involved; the swap can convert fixed exposure into floating exposure through netting of fixed and floating legs.
- The net payoff is not solely driven by the asset’s fixed 3% coupon because the swap’s floating leg introduces variability; the fixed 3.5% paid by A and the fixed 3% received from the asset do not perfectly offset in the presence of the floating LIBOR+0.5% received by A.
- The result cannot be described as a fixed-rate asset since the net cash flows depend on LIBOR, which makes the total payoff floating.

Summary of the reasoning trajectory:
- Compare asset cash flow (fixed) with swap cash flows (receive floating LIBOR+0.5, pay fixed 3.5).
- Net the fixed components: asset 3% vs swap fixed 3.5% → net fixed outflow of 0.5% of notional for the swap leg.
- Net the floating components: receive LIBOR from the swap; add the 0.5% premium from the floating leg, which cancels with the 0.5% fixed difference, yielding a LIBOR-only exposure after netting.
- The combined asset+swap position exhibits floating-rate characteristics aligned with LIBOR.

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