Explanation:
C is correct. The company is hedging against rising interest rates, that means the company wants to pay at the fixed rate.
Cash flowᵢ = notional * (floating rateᵢ − fixed rate) * length of period
Cash flow at end of year 2 = 100,000,000 * (2.7% + 30/10,000 − 2.75%) * 0.5 = 125,000
A is incorrect. This would be the cash flow if the company pays floating and receives fixed.
B is incorrect. This omits the 30 bps spread from the calculations.
D is incorrect. This is the sum of net cash flows over 2 years.
Learning Objective: Explain the mechanics of a plain vanilla interest rate swap and compute its cash flows.
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Q-85. The treasurer of a large manufacturing company has decided to hedge against rising interest rates. The treasurer wants to enter into a 2-year fixed-for-floating swap with a notional of USD 100 million, a fixed annual interest rate of 2.75%, semi-annual payments, and a floating interest rate of 6-month SOFR plus 30 bps, starting in January of Year 1. The treasurer uses the following forecast of future 6-month SOFR rates:
| Time period | Rate |
|---|---|
| Jan-Jun Year 1 | 2.40% |
| July-Dec Year 1 | 2.57% |
| Jan-Jun Year 2 | 2.66% |
| July-Dec Year 2 | 2.70% |
Which of the following is the best estimate of the net cash flow that the treasurer expects for the company to receive at the end of year 2?
A. USD −125,000
B. USD −25,000
C. USD 125,000
D. USD 265,000
A
USD −125,000
B
USD −25,000
C
USD 125,000
D
USD 265,000
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