Firm ABC enters a 5-year swap with firm XYZ to pay LIBOR in return for a fixed 6% rate on notional principal of $10 million. Two years from now, the market rate on 3-year swaps is LIBOR for 5%; at this time, firm XYZ goes bankrupt and defaults on its swap obligation.

a. Why is firm ABC harmed by the default?

b. What is the market value of the loss incurred by ABC as a result of the default?

c. Suppose instead that ABC had gone bankrupt. How do you think the swap would be treated in the reorganization of the firm?