Bank of America has made a 300 million loan to a software co

Bank of America has made a $300 million loan to a software company at a fixed rate of 7%. The bank wants to hedge its exposure by entering into a total return swap with a counterparty, Interloan Co., in which Bank of America promises to pay the interest on the loan plus the change in the market value of the loan in exchange for LIBOR plus 125bp. If after one year the market value of the loan has increased by 1.8% and LIBOR is 5%, what will be the net obligation of Interloan?

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Solution

Fixed rate -7%

Market Valueof asset increase by 1.8% i.e up from $300m to $305.4m

The buyer make payment from reference asset- 0.07*$300m= $21 M

The buyer recieve payment from reference asset- 0.0625*$300m=$18.75 m

The buyer will not make any payment to reflect the change in market value as its value as increased

Net obligation= +21-18.75+5.4= + $7.65 m

Total cash flow= -21+18.75-1.8=