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ACCA Strategic Professional · Advanced Financial Management · The use of financial derivatives to hedge against interest rate risk

Delta plc has a 5-year floating-rate loan of $50m at SOFR. It enters a pay-fixed swap on the full notional at 3.5% for settlement annually in arrears. At the first settlement SOFR for the period is 4.5%. What is the net swap settlement for Delta, and what is the overall interest cost on the loan for that year including the swap?

Delta receives a net $0.5m and its overall interest cost is $1.75m. SOFR of 4.5% exceeds the 3.5% fixed rate by 1%, giving $0.5m on $50m. Loan interest of $2.25m less this receipt equals $1.75m, which is the locked-in 3.5%.

  1. AReceives $0.5m; overall interest cost $1.75mCorrect
  2. BPays $0.5m; overall interest cost $2.75m
  3. CReceives $0.5m; overall interest cost $2.25m
  4. DReceives $1.0m; overall interest cost $1.75m

Explanation

Delta receives SOFR 4.5% and pays 3.5%, net receipt 1.0% x $50m = $0.5m? That equals $0.5m, since 1% of $50m is $0.5m. Loan interest = 4.5% x $50m = $2.25m. Net cost = $2.25m - $0.5m = $1.75m, equal to 3.5% x $50m. The $1.0m option miscalculates 1% of the notional.

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