After discussing the various equity swap options with Fairfax, Potter checks his e-mail and reads a message from Clark Ali, a client of Potter and the treasurer of a firm that issued floating rate debt denominated in euros at London Interbank Offered Rate (LIBOR) + 125 basis points. Now Ali is concerned that LIBOR will rise in the future and wants to convert this into synthetic fixed rate debt. Potter recommends that Ali: A) take a short position in Eurodollar futures. B) enter into a pay-fixed swap. C) enter into a receive-fixed swap. . . . . . . . . . . . . . . . Your answer: C was incorrect. The correct answer was B) enter into a pay-fixed swap. ---- The way I saw it, a company issued debt - that means they’re paying LIBOR + 125 each payment period. In order to turn this floating into fixed, they need to enter an agreement where each period they receive LIBOR. Thus, their payments would be: -(LIBOR + 125) + LIBOR —> -125 What am I missing here? Why would they enter into a pay-fixed swap?
you want to receive floating when you think rates are going up, and pay fixed. you gain what the interest savings on the transaciton (if i pay at 5%, and receive, lets say, 8%, i save 3%). So if you think rates are going up, you want to receive the higher interest, and in return lock in a smaller fixed rate. Choice B.
They are paying floating. If the floating rate rises - they will pay more. the way to hedge that would be to receive floating - and they can receive floating by entering into a pay fixed, receive floating swap. that way the two floating cancel out - and they are hedged against the possibility of the rate rising.
kinda interest rate collar
Ohhhhhh. I wasn’t thinking about the two sides of the swap contracts. I was just thinking that they needed to receive something to cancel out the floating. Makes sense now. Thanks.