The Prince Racket Company manufactures a line of tennis and
The Prince Racket Company manufactures a line of tennis and raquetball equipment. The firm recently entered into a loan agreement for $20 million that carries a floating rate of interest equal to LIBOR plus 100 basis points (1 percent). The loan has a five-year maturity and requires the firm to make semiannual payments. At the time the loan was being negotiated, the company was approached by its banker with a suggestion as to how the firm might lock in the rate of interest on the loan at 8 percent using a fixed-for-floating interest rate swap. Under the agreement the company would make a cash payment to the swap counterparty equal to the fixed-rate coupon payment and receive in return a coupon payment reflecting the floating rate.
a. Calculate the swap cash flows over the next five years based on the following set of hypothetical LIBOR rates:
Year (A) 6-Month LIBOR Rate (B)
0.00 ........... 6.80%
0.50 ........... 7.20%
1.00 ........... 8.00%
1.50 ........... 7.40%
2.00 ........... 7.80%
2.50 ........... 8.60%
3.00 ........... 9.00%
3.50 ........... 9.20%
4.00 ........... 8.40%
4.50 ........... 7.60%
5.00
b. What would motivate a firm’s management to enter into such a swap contract?

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