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IAI Actuarial Core Principles · Business Finance · Financial instruments issued or used by companies

A company has a floating-rate rupee loan and enters a swap in which it pays a fixed rate of 8% a year and receives the floating rate on the same notional. Which statement describes the effect on the company?

The company turns its floating-rate loan cost into an effectively fixed cost of about 8%. The floating amount it receives on the swap offsets the floating interest it pays on the loan, leaving the fixed payment. The notional is not exchanged and the loan principal is unchanged.

  1. AIt converts its floating-rate interest cost into an effectively fixed costCorrect
  2. BIt converts its fixed-rate asset into a floating-rate asset
  3. CIt increases its exposure to rises in the floating rate
  4. DIt removes credit risk because the swap principal is exchanged at maturity
  5. It reduces the loan principal by the notional amount

Explanation

The floating receipt from the swap offsets the floating interest payable on the loan, leaving the company paying the fixed 8%. The notional principal is normally not exchanged in an interest rate swap, so option 3 is wrong. The swap does not change the loan principal.

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