Explanation:
TIEN’s payment: USD 50 million × × 12% = USD 3,000,000
Counterparty’s payment: USD 50 million × × 13.5% = USD 3,375,000
So TIEN would receive: USD 375,000 (net)
Note: At the start of a period (like the 6 months in this example), we don't know what the floating interest rate will be at the end of that period. So, to plan for cash flows and manage risk, we use the rate that's known at the beginning of the period, i.e., the rate from the last settlement date. At the start of each new period, the rate is reset based on the current prevailing rate, which then determines the cash flows for the upcoming period.
Ultimate access to all questions.
Q.38 Tiara Enterprises (TIEN) has just announced its plans to establish a facility in New York, USA, to meet the increased demand for its products. TIEN plans to fund the expansion with debt, and in order to hedge the risk of borrowing, TIEN has entered into a plain vanilla interest rate swap with a notional principal of USD 50 million. TIEN would make semiannual payments at the rate of 12% with the counterparty making floating rate payments at the Euribor rate. Assuming a 360-day year, if the Euribor was 13.5% on the last settlement date and is 11.0% on the current settlement date, the amount that TIEN would receive at the last settlement date is closest to:
A
USD 250,000.
B
USD 625,000.
C
USD 375,000.
D
USD 312,500
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