A firm can borrow at fixed AA rates for long-term loans.If it swaps its long-term payments so that it receives the fixed AA rate and pays a AA floating rate,what is the rate of interest on its borrowing if the floating rate is r% and the fixed rate is 1%?
A)r + 1%
B)r - 1%
C)r%
D)1%
E)2%

Question

Quizplus · Accepted Answer

In a swap, the two parties exchange cash flows based on different instruments or rates. In this case, the firm chooses to receive payments at the fixed AA rate and pay at the AA floating rate.

Initially, the firm was paying a fixed rate of 1%. But after the swap, it will receive the fixed AA rate and pay the AA floating rate, which we assume to be r%.

The overall rate of interest on the firm's borrowing is the difference between the fixed AA rate and the floating AA rate. As the firm receives the fixed AA rate and pays the AA floating rate, the rate of interest is:

Fixed AA rate - AA floating rate = 1% - r% = (1-r)%

Therefore, the rate of interest on the firm's borrowing after the swap is (1-r)%. And the closest answer choice to this is C) r%.

A Firm Can Borrow at Fixed AA Rates for Long-Term