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Answer: Net inflow of USD 0.3 million
## Explanation Let's calculate the cash flows step by step: **Given:** - Loan amount: USD 100 million - Loan interest rate: 8% per annum - LIBOR: 6% - Credit spread: 30 basis points (0.30%) - Mark-to-market value change: -2% (fall) **Cash flows for RAB:** 1. **What RAB pays:** - Interest on loan: 8% × USD 100 million = USD 8 million - Change in mark-to-market value: -2% × USD 100 million = -USD 2 million (negative means RAB pays less) - Total payment: USD 8 million + (-USD 2 million) = USD 6 million 2. **What RAB receives:** - LIBOR + 30 bps: 6% + 0.30% = 6.30% - Receipt: 6.30% × USD 100 million = USD 6.3 million **Net cash flow for RAB:** - Receipt - Payment = USD 6.3 million - USD 6 million = USD 0.3 million Therefore, RAB has a **net inflow of USD 0.3 million**. **Key insight:** The total return swap allows RAB to transfer both the credit risk (interest payments) and market risk (value changes) of the loan to the counterparty. When the loan value falls, RAB pays less on the swap, resulting in a net positive cash flow when combined with the fixed LIBOR-based receipt.
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Risk Averse Bank (RAB) has made a loan of USD 100 million at 8% per annum. RAB wants to enter into a total return swap under which it will pay the interest on the loan plus the change in the mark-to-market value of the loan, and in exchange, RAB will get LIBOR + 30 basis points. Settlement payments are made annually. What is the cash flow for RAB on the first settlement date if the mark-to-market value of the loan falls by 2% and LIBOR is 6%?
A
Net inflow of USD 0.3 million
B
Net outflow of USD 0.3 million
C
Net inflow of USD 1.7 million
D
Net outflow of USD 1.7 million