The Water & Sewer Department (WSD) of the City of Sacramento

(California) has issued a floating rate note (FRN) maturing in seven years with an interest rate pegged to the U.S. dollar six-month LIBOR + 0. 25 percent

(25 basis points). The Water & Sewer Department is concerned that short-term interest rates may be trending upward and decides to protect itself against price resetting risk. The swap desk at Wachovia Bank quotes a seven-year interest rate swap whereby WSD would pay a fixed rate of 5 percent for the next seven years and receive LIBOR, with both payments made semiannually.

a. What is the nature of the swap offered by Wachovia Bank? How does it protect WSD against interest rate risk?

b. Assuming that LIBOR stands at 3. 75 percent, compute the first payment and indicate the payment(s) that WSD makes/receives.