Question

E9.13 Interest Rate Swap: Profit and Default On July 1, 2020, Queen Corp. and Prince, Inc. entered into an interest rate swap on a notional amount of $1 million. They accepted the following offer of Intermediary: To Intermediary from Queen ..... To Intermediary from Prince...... To Queen from Intermediary .... To Prince from Intermediary......... LIBOR + 30 (floating) 2.4% (fixed) 2.3% (fixed) LIBOR + 20 (floating) ........ At inception of the swap, LIBOR = 2.3 percent. Due to an increase of 20 bp in the floating interest rate at the end of September, Queen Corp. defaulted and Intermediary honored its commitment to Prince, Inc. by continuing with the swap. Required a. What monthly profit, in dollars, was Intermediary making on the swap before default? b. Is Intermediary losing money after the default? If so, how much?

Answer 1

a. LIBOR = 2.3% @ inception. Since we are using LIBOR, we are using the (30/360) days convention throughout the calculation

Intermediary's commitment with Queen before Queen's default:

Receive: LIBOR + 30 = 2.3%+.3% = 2.6%

Pay: 2.3%

Monthly Profit =

0 (0.026 -0.023) * * 1,000,000

= 250.......(1)

Intermediary's commitment with Prince before Queen's default:

Receive: 2.4%

Pay: LIBOR + 20 = 2.3%+.2% = 2.5%

Monthly Loss =

(0.025 - 0.024) + 1,000

= 83.33.......(2)

Monthly Net Profit for Intermediary = 250-83.33 = 166.67 dollars ............[(2)-(1)]

b. Intermediary's commitment with Prince after Queen's default:

LIBOR = 2.3% + 20 bps = 2.5%

Receive: 2.4%

Pay: LIBOR + 20 = 2.5%+.2% = 2.7%

Monthly Loss =  

(0.027 - 0.024) + 1,000

= 250 dollars

So Intermediary is losing 250 dollars every month after Queen's default.