QUESTION 5 X Inc has entered into contract with its lender bank to pay off 10% $ 10 Million loans due in 5 years against 9% $ 10 Million of the same maturity. Current market yield is 9%. This contract has been entered into in the context of declining interest rate scenario. PV of annuity at 9% for 5 years 3.8997 and PV at 9% at 5th year 0.6499. Is it a financial instrument?
Yes, the contract entered into by X Inc. with its lender bank to pay off 10% $ 10 Million loans due in 5 years against 9% $ 10 Million of the same maturity is a financial instrument.
The contract involves a contractual right to receive cashflows in the form of interest payments and principal repayments at a specified rate and maturity. The contract also has an economic value that can be measured reliably.
The contract is a type of interest rate swap where X Inc. is exchanging a higher interest rate obligation for a lower interest rate obligation. The present value of the annuity payments of the 10% loan at 9% discount rate is $ 7,919,400, and the present value of the principal payment is $ 6,499,000. The present value of the annuity payments of the 9% loan at 9% discount rate is $ 7,919,400, and the present value of the principal payment is $ 6,499,000.
The difference between the present value of the cash flows exchanged by X Inc. and the fair value of the contract at the date of inception represents the initial net investment in the contract. In this case, the net investment is zero since the fair value of the contract at inception is equal to the present value of the cash flows exchanged.
