Consider a bank that holds a $5 million loan at a fixed rate of 6% for three years, with quarterly payments. The bank had originally funded this loan at a fixed rate, but because of changing interest rate expectations, it has now decided to fund it at a floating rate. Although it cannot change the terms of the loan to the borrower, it can effectively convert the loan to a floating-rate loan by using a swap. The fixed rate on three-year swaps with quarterly payments at Libor is 7%. We assume the number of days in each quarter to be 90 and the number of days in a year to be 360.

A. Explain how the bank could convert the fixed-rate loan to a floating-rate loan using a swap.

B. Explain why the effective floating rate on the loan will be less than Libor.