Swaps

CFA Level III
#1

R34 EOC 24.

WMTC originally enters a five-year variable rate loan. Principal amount: $10,000,000. Rate: Libor + 200 basis points, paid semiannually, reset every six months. Loan rate was reset today at a Libor of 5%.

Company now thinks interest rate will increase.

To hedge the interest rate risk on the five-year variable rate loan, Lopez recommends that WMTC enter into a contract with Swap Traders International (STI), who offers an interest rate swap with a notional principal of $10 million that provides a fixed rate of 6% in exchange for Libor, with semiannual payments.

The way it is written, it makes it sound like STI will pay 6% fixed rate and receive Libor. But the proper way to set this up is to have STI pay Libor and receive fix.

Is this a typo? Or is this a play on words?

#2

No, the text is right.

You want to pay fixed and receive libor.

They are in a loan and they are paying libor +2%. They are afraid rates are increasing, so they need a fixed rate. They take a swap as the payer. The net is the libors cancel out and ends up paying 6% + 2% = 8%.

#3

I know I want to pay fix, receive Libor. My question is more on semantics.

If a dealer offers a swap that provides a fixed payment of 6%. I buy the swap (or agree to enter), this means I pay the fixed payment.

This is counterintutitive, which is ok. I’ll roll with this for the test, but I want to make sure this is what CFA intended, and not a typo.

#4

A long (buyer) position in the swap is the payer of fixed.

#5

I suspect that it’s neither.

I think that if they had written, “. . . that provides for a fixed rate . . .” it would have been clearer. To me, that would suggest only that they’re describing the two legs, not who would pay which one.