XYZ Company currently has a $20 million floating rate loan that has 4 years left until maturity. Interest rate of LIBOR + 1% is paid annually on this loan. Concerned with increases in interest rates, XYZ wants to convert this loan into a fixed rate loan by entering into a swap transaction. Its bank offers XYZ a swap transaction in which LIBOR is exchanged with 10% on a notional principle of $20 million.
a. Determine the type of payments XYZ Company has to make and receive in this swap transaction in order to achieve its objective.
b. Suppose that XYZ Company entered into the swap transaction offered by its bank. Exactly a year and half after the creation of the swap transaction, determine the value of the swap to XYZ Company, if the next floating payment that will be made in 6 months is based on an interest rate of 9.75%, and the yield to maturity on fixed rate loans with similar risk and time to maturity is 11% per year.
c. Identify whether the swap is an asset or a liability for the XYZ Company.