Bank One enters into a fiveyear swap contract with Mervin Co

Bank One enters into a five-year swap contract with Mervin Co. to pay LIBOR
in return for a fixed 8% rate on a principal of $100 million. Three years from
now, the market rate on 2-year swaps at LIBOR is 7%. At this time,
Mervin Co. declares bankruptcy and defaults on its swap obligation. Assume
that the net payment is made only at the end of each year for the swap contract
period. What is the market value of the loss incurred by Bank One as a result
of the default?

Question options:

1)

2)

3)

4)

Solution

Given that Bank one has to pay libor in return of fixed 8% return on a principal of $100m.

Now after two year libor is 7% it means bank one will have net benefit of 1 % on 100 m .But mervin company got bankrupt.Therefore,

Market value of loss incurred by bank one =discounted value of net interest payment or (8-7)%of $100m=$1m discounted at 7% which is $934579+$873439+$816298=$2624316 or2.624m

Hence correct answer is option (3)