# Example #1 - Reading #28 - Swaps

Can someone please assist me in understanding this???

I’m completely on top of Exibit #1 (Converting Floating to Fixed)*

*From perspective of borrower

However, I can’t get my head around Example #1 for the life of me… My understanding is as follows:

1. perspective of the lender who issued a Fixed rate loan

2. now wants to convert this loan after the fact to essentially a Floating Rate loan

Summary of question…

*bank holds a \$5M loan at fixed rate of 6% for 3 years w/ Quarterly payments

* now decided to find it at a Floating Rate

*cannot change terms but effectively can convert to floating using swap

*fixed rate on 3-year swap w/ Q payments @ Libor = 7%

*Assume the # days each Q are 90 and # days in year is 360

Question A: explain how bank can covert the fixed rate loan using swap

Question B: explain why the effective floating rate on loan will be less than Libor

Solution A… Interest payment receive on loan are \$5,000,000(0.06)(90/360) = \$75,000. Bank could do a swap to pay fixed rate of 7% and receive a floating rate of Libor. It’s fixed payment would be \$5,000,000(0.07)(90/360) = \$87,500. The floating payment would receive it \$5,000,000(L)(90/360), where L is Libor est. at previous reset date. Overall CF is thus \$5,000,000(L-0.01)(90/360). Libor MINUS 100 bps.

*****please explain and especially the (L-0.01)… No clue where the 100 bps is coming from… (Difference btw the 6% and 7% but no clue why???)

Solution B: ???

Pay Floating (L) on Swap, Received Fixed (7%)

Bank also pays 6% Fixed (on Original Loan)

So Net cash flow from Bank side = -6% (Fixed) + Receive Fixed (7%) - L (Pay Floating) = - L + 1 = Pay -(L-1) Net.

This is each period.