John is the CFO of company A and one of his recent tasks is to borrow $10 million for 3 years to fund the companys newly initiated project. Due to the pattern of expected cash flows generated from the to-be-funded project, John wants to have a loan with a fixed rate. He called his banks and received quotes on fixed-rate 8.0% and floating-rate 0.5% above the LIBOR. All rates are annualized rate in quarterly compounding.

John passes this information to his regular financial consultant Tom to seek advice. After receiving this information, Tom quickly links this case with his another customer Bob, who is the CFO of company B. Bob is looking for a $10 million 3-years floating rate loan and has received a floating rate quote 1.5% above the LIBOR and a fixed rate quote 8.5%. All rates are annualized rates in quarterly compounding.

Tom immediately realizes that he can make a decent revenue by organizing separate swap contracts with John and Bob simultaneously.

Tom decides to charge 14bps (i.e., 14 basis point, 1% = 100bps), and let John and Tom equally share the rest of benefit if there is any left.

Part I.

Design a swap contract between company A and FI which Tom works for, show your working/analysis process explicitly. Use the following table to organize key information in swap contract arrangement. With the swap contract with FI, what is the net interest rate that company A has to pay for the loan?

Part II.

Both deals went smoothly until Company B claimed bankruptcy. By that time, there were still 14 months left before the swap contract between the FI and Company B expired. As a result, Tom needs to evaluate the swap contract with Bob and immediately assess the possible loss. Lets assume that in the swap contract, Toms company pays 7.22% per annum and receives 3-month LIBOR in return on a notional principal of $10 million with payments being exchanged every three months. One month ago, the 3-month LIBOR rate was 7.5% per annum. Assume the zero rate is 7.45% per annum for all maturities. All rates are annualized rates and compounded quarterly. What is the value of the swap on FIs book? You need to show your analysis/calculation process explicitly.

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