- CFA Exams
- CFA Level I Exam
- Study Session 16. Derivatives
- Reading 49. Basics of Derivative Pricing and Valuation
- Subject 6. Pricing and Valuation of Swap Contracts

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**CFA Practice Question**

Two parties enter into a three-year interest rate swap, which involves the exchange of LIBOR+1% for a fixed rate of 12% on a $100 million notional amount. The LIBOR rate today is 11%, but is expected to increase to 15% in one year and then fall back down to 8%. Which statement accurately depicts the flow of net cash flows between the two counter-parties?

A. The variable rate payer would receive a payment of $4 million at the end of year two, while the fixed rate payer would receive $3 million at the end of year three.

B. The fixed rate payer would receive a payment of $4 million at the end of year two, while the variable rate payer would receive $3 million at the end of year three.

C. The fixed rate payer would have to pay $3 million at the end of the second year and $3 million at the end of the third year.

**Explanation:**With a variable of LIBOR + 1%, the effective interest payment for the variable rate payer will be 12% in year one, 16% in year two, and 9% in year three.

End of year 1: fixed pays ($100million * 12%): $12 million; Variable pays ($100million * 12%): $12 million. Net cash flow received by fixed payer: NIL.

End of year 2: fixed pays ($100million * 12%): $12 million; Variable pays ($100million * 16%): $16 million. Net cash flow received by fixed payer: $4 million.

End of year 3: fixed pays ($100million * 12%): $12 million; Variable pays ($100million * 9%): $9 million. Net cash flow received by variable payer: $3 million.

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**User Contributed Comments**
1

User |
Comment |
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siggarusfigs |
"The Libor rate today is 11%"-- it is the rate at t=0 which is used to calculate the return a year from now. |