A corporation has a $100M floating-rate loan at SOFR + 1.5%. It enters a swap paying 3.5% fixed and receiving SOFR. What is the corporation's effective net interest cost after combining the loan and swap?
A3.5% fixed — the swap rate replaces the original loan rate
BSOFR + 1.5% — the swap is a separate contract and does not affect the loan
C5.0% fixed — the SOFR payments cancel, leaving the fixed rate plus the spread
D2.0% fixed — the swap rate minus the floating spread
Combining the loan and the swap: pay SOFR + 1.5% (loan) + pay 3.5% fixed (swap) − receive SOFR (swap) = 3.5% + 1.5% = 5.0% fixed. The SOFR component in the loan and the SOFR received from the swap cancel exactly. The firm has synthetically converted floating-rate debt into 5.0% fixed-rate debt without refinancing the underlying loan. This is the essential function of an interest rate swap — not replacing the debt, but layering a separate contract that transforms the interest rate exposure.
Question 2 Multiple Choice
Six months after entering a pay-fixed, receive-floating swap at a 4% fixed rate, long-term rates rise to 6%. What happens to the market value of the swap for the fixed payer?
AThe value falls — being locked into paying 4% when market rates are 6% is unfavorable
BThe value rises — the firm is paying a below-market fixed rate, making the position favorable
CThe value is unchanged — swaps are always priced at zero by construction
DThe value depends only on changes in the floating rate received, not the fixed rate paid
When rates rise to 6%, new fixed payers would have to pay 6% on a new swap. This firm is locked in at only 4% — below the current market rate. The fixed payer is now paying cheap relative to what a new swap would cost, while receiving floating payments that have risen. The net present value of remaining cash flows has turned positive for the fixed payer. Option A commits the key error: 'paying 4% when rates are 6%' sounds unfavorable, but being locked in at 4% when the market demands 6% is the favorable side of the trade.
Question 3 True / False
In an interest rate swap, the notional principal is exchanged between counterparties at the initiation of the contract.
TTrue
FFalse
Answer: False
This is the most fundamental structural feature of swaps. The 'notional' in notional principal means the amount exists in name only — it determines the size of the interest payments but is never transferred between parties. Only the periodic interest cash flows are exchanged. This is what makes swaps efficient: a firm can transform the rate profile of a $100M loan by exchanging only the interest differential, without moving or encumbering the principal itself.
Question 4 True / False
At the moment an interest rate swap is initiated, it has zero net present value to both counterparties.
TTrue
FFalse
Answer: True
The swap rate — the fixed rate paid by the fixed payer — is specifically chosen so that the present value of the fixed cash flows equals the present value of the expected floating cash flows on the initiation date. This makes the initial value zero for both sides: neither party pays a premium to enter. Compare this to an option, where one side pays a premium upfront. After initiation, as interest rates move, the swap develops a positive value for one side and an equal negative value for the other.
Question 5 Short Answer
Why do companies use interest rate swaps rather than simply refinancing their debt to achieve a different interest rate profile? What advantages do swaps offer?
Think about your answer, then reveal below.
Model answer: Refinancing is costly, time-consuming, and may require paying prepayment penalties, renegotiating loan terms, and reestablishing credit relationships. A swap achieves the same economic transformation — converting fixed to floating or floating to fixed — through a separate contract that leaves the underlying debt untouched. Swaps are also liquid and reversible: a position can be exited by entering an offsetting swap or selling the position in the OTC market. The combination of low transaction costs, flexibility, and speed makes swaps far more practical than repeated debt restructuring for managing interest rate exposure.
The key organizational insight is that funding decisions and risk management decisions can be separated. A firm might raise fixed-rate debt because the bond market is favorable at that moment, then use a swap to convert to floating if that better matches their asset profile — without issuing new debt. This decomposition lets treasury and risk management operate independently. It also enables temporary adjustments: a swap can be unwound when the exposure no longer exists, without modifying the underlying financing.