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Forums › Ask CIMA Tutor Forums › Ask CIMA P3 Tutor Forums › Interest Rate Swaps
I wondered if you could please help with this question & answer.
Question
James has £5m investment that pays Libor + 4%
Joe has a £6m investment that pays fixed rate of 6% per month
James & Joe agree to enter an interest rate swap
What is Libor if James pays Joe £40,000.
Answer
Work out the fixed interest of 6% = £6m x 6% = £360,000
So Joe gains interest of £360,000. We also know that James pays £40,000 to Joe as they’ve promised to swap interest.
That means that the interest James earns must be £400,000(£360,000 +£40,000)
Now that we know this we can work out the Libor rate
£5m x (Libor + 4%) = £400,000. So £400,000/£5,000,000 = 0.08 = 8%
Libor + 4% = 8%. So Libor = 4%
I do not understand how they arrived at the fact that James must have paid £400,000
Can you help me?
Thanks
Joe receives interest of 360,000 now. After the swap he will still receive that plus he gets 40,000, from James, ie 400,000 in total. This is equivalent to Jame’s receipt, because they have swapped their interest income.