Diagram an interest rate risk swap. Start by drawing 2 boxes. Label them Firm A and Commercial Bank. Firm A gets a $300,000 loan from their neighborhood commercial bank. Each month for 5 years, Firm A must pay the commercial bank a principle payment and an interest payment of the principle times LIBOR + .06. (LIBOR stands for the London Interbank Offer Rate, it is a base interest rate used when banks lend money to each-other. It is common practice to base commercial and mortgage loan interest rates off of LIBOR instead of the US Federal Funds Rate. LIBOR is a more volatile rate than the Fed rate.) Firm A’s monthly payment: prin + prin * (LIBOR + .06) Draw the flows between Firm A and the commercial bank.

The commercial bank and the investment bank form a 5-year contract to swap interest rate risk.

Each month, the commercial bank will pay the investment bank:

a. prin + prin * (LIBOR + .06)

b. prin

c. prin * (LIBOR + .06)

d. prin * (LIBOR)

e. prin * (.06)