[Solution]A financial institution has entered into an interest rate swap with company X

A financial institution has entered into an interest rate swap with company X. Under theterms of the swap, it receives 10% per annum and pays…

A financial institution has entered into an interest rate swap with company X. Under theterms of the swap, it receives 10% per annum and pays 6-month LIBOR on a principal of$10 million for 5 years. Payments are made every 6 months. Suppose that company Xdefaults on the sixth payment date (at the end of year 3) when the interest rate (withsemiannual compounding) is 8% per annum for all maturities. What is the loss to thefinancial institution? Assume that 6-month LIBOR was 9% per annum halfway throughyear 3.

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