Marx and Winter, Inc. operate a chain of retail clothing stores throughout the U.S. Midwest. The firm recently entered into a loan agreement for $20 million that carries a floating rate of interest equal to LIBOR plus 50 basis points (1/2 percent). The loan has a five-year maturity and requires the firm to make semiannual payments. At the time the loan was being negotiated, Marx and winter was approached by its banker with a suggestion as to how the firm might lock in the rate of interest on the loan at 6.4 percent using a fixed-for-floating interest rate swap. Under the agreement the company would make a cash payment to the swap counterparty equal to the fixed-rate coupon payment and receive in return a coupon payment reflecting the floating rate.

a. Calculate the swap cash flows over the next five years based on the following set of hypothetical LIBOR rates:

Year (A) Six-Month LIBOR Rate (B)

0.00 ............5.44%

0.50 ............7.20%

1.00 ............6.40%

1.50 ............5.92%

2.00 ............6.24%

2.50 ............6.88%

3.00 ............7.20%

3.50 ............7.36%

4.00 ............6.72%

4.50 ............6.08%

5.00

b. What would motivate a firm’s management to enter into a swap contract?