A company plans to take out a $10 million floating-rate loan in two years. The loan will be for five years with annual payments at the rate of Libor. The company anticipates using a swap to convert the loan into a fixed-rate loan. It would like to purchase a swaption to give it the flexibility to enter into the swap at an attractive rate. The company can use a payer or a receiver swaption. Assume that the exercise rate would be 6.5%.

A. Identify what type of swaption would achieve this goal and whether the company should buy or sell the swaption.

B. Calculate the company’s annual cash flows beginning two years from now for two cases: The fixed rate on a swap two years from now to terminate five years later, FS(2,7), is 1) greater or 2) not greater than the exercise rate. Assume the company takes out the $10 million floating-rate loan as planned.

C. Suppose that when the company takes out the loan, it has changed its mind and prefers a floating-rate loan. Now assume that the swaption expires in-the-money. What would the company do, given that it now no longer wants to convert to a fixed-rate loan?