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? Net receipt of $7.65 million Net payment of $4.8 million Net receipt of $9.6 million Net payment of $5.2 million

Solution

Value of the asset increased by $5.4m i.e by 1.8%

Amount recieved by bank- 7% of $300m= $21 m

Amount paid by Bank= 6.25% of $300m= $18.75%(no payment will be done for increase in value as it goes to receiver)

Net obligation will be = $21m-$18.75+$5.4= Net receipt of $7.65m