Imagine that Company XYZ has secured a 5-year loan amounting to $500 million, with an annual interest rate of 5.2%. The company decides to enter into an interest rate swap agreement, under which it agrees to receive a fixed interest rate of 4.8% and pay a floating interest rate pegged to the LIBOR. Based on this arrangement, what is the net interest rate paid by the company after entering the swap agreement?

Question

BlackTom AI · Accepted Answer

To analyze the overall cost, start by separating the two components: the loan interest and the swap cash flows.
First, the company has a loan at 5.2% per year on $500 million. This means it will pay 5.2% of 500 million in interest annually, independent of any swap.
Next, consider the interest rate swap: the company agrees to receive a fixed rate of 4.8% and to pay a floating rate equal to LIBOR. In a standard swap, receiving fixed and paying floating means the company effectively exchanges its loan’s fixed obligation for a floating obligation, with the fixed amount it receives offsetting part of its loan cost.
The net effect of the swap on the company’s cash flow is: it pays LIBOR on the swap and receives 4.8% in fixed payments. Net swap cash flow = LIBOR − 4.8% (as a payment to the counterparty, the company is paying more when LIBOR is above 4.8% and less when LIBOR is below). However, since the company still carries the loan at 5.2%, the total annual interest cost becomes:
Total = loan interest (5.2%) + net swap cash flow (LIBOR − 4.8%).
Combining these terms gives: Total = LIBOR + (5.2% − 4.8%) = LIBOR + 0.4%.
Now evaluate the options:
- The company pays LIBOR+0.4% per year. This matches the derived total cost, considering both the fixed loan rate and the net effect of the swap.
- The company pays 4.8% per year. This would only be correct if the loan were entirely offset by the swap’s fixed receipt, which isn’t the case here since the loan is 5.2% and the swap involves paying LIBOR.
- The company pays LIBOR-0.4% per year. This would imply a reduction below LIBOR, which contradicts the fixed loan cost and the net fixed receipt of 4.8%.
- The company pays 5.2% per year. While the loan alone is 5.2%, the swap modifies the overall cost, so the total is not simply the loan rate; you must account for the swap’s fixed receipt of 4.8% and the fixed-to-floating exchange, yielding LIBOR+0.4% rather than the straight 5.2%.
In summary, the combined effect of paying the loan rate and the net swap payments leads to a total cost of LIBOR plus 0.4% per year, which aligns with the first option.

BU.232.710.F1.SP25 Quiz #1- Requires Respondus LockDown Browser

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