Can someone please assist me in understanding this???
I’m completely on top of Exibit #1 (Converting Floating to Fixed)*
*From perspective of borrower
However, I can’t get my head around Example #1 for the life of me… My understanding is as follows:
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perspective of the lender who issued a Fixed rate loan
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now wants to convert this loan after the fact to essentially a Floating Rate loan
Summary of question…
*bank holds a $5M loan at fixed rate of 6% for 3 years w/ Quarterly payments
* now decided to find it at a Floating Rate
*cannot change terms but effectively can convert to floating using swap
*fixed rate on 3-year swap w/ Q payments @ Libor = 7%
*Assume the # days each Q are 90 and # days in year is 360
Question A: explain how bank can covert the fixed rate loan using swap
Question B: explain why the effective floating rate on loan will be less than Libor
Solution A… Interest payment receive on loan are $5,000,000(0.06)(90/360) = $75,000. Bank could do a swap to pay fixed rate of 7% and receive a floating rate of Libor. It’s fixed payment would be $5,000,000(0.07)(90/360) = $87,500. The floating payment would receive it $5,000,000(L)(90/360), where L is Libor est. at previous reset date. Overall CF is thus $5,000,000(L-0.01)(90/360). Libor MINUS 100 bps.
*****please explain and especially the (L-0.01)… No clue where the 100 bps is coming from… (Difference btw the 6% and 7% but no clue why???)
Solution B: ???