JonesCorp just entered into a plain vanilla interest rate swap as the fixed-rate receiver. The swap has a tenor of four years and makes payments quarterly on a netted basis. At the time the swap was initiated the LIBOR term structure was flat causing LIBOR to be equal to the swap fixed rate. Under which of the following circumstances would JonesCorp be required to make a future net payment to the swap counterparty?
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A. B. C.A
In this scenario, JonesCorp has entered into a plain vanilla interest rate swap as the fixed-rate receiver. A plain vanilla interest rate swap involves the exchange of fixed-rate and floating-rate cash flows based on a notional principal amount.
Let's analyze each answer choice to determine under which circumstance JonesCorp would be required to make a future net payment to the swap counterparty:
A. The LIBOR term structure becomes upward sloping: If the LIBOR term structure becomes upward sloping, it means that interest rates for longer maturities are higher than those for shorter maturities. In this case, the floating rate payments that JonesCorp receives based on LIBOR would be higher than the fixed rate it has agreed to pay. As a result, JonesCorp would not be required to make a net payment to the swap counterparty. Therefore, this answer choice is incorrect.
B. The LIBOR term structure remains flat but shifts down: If the LIBOR term structure remains flat but shifts down, it means that interest rates for all maturities decrease, including the floating rate based on LIBOR. Since the fixed rate agreed upon in the swap is equal to the initial LIBOR rate, there would be no change in the relative rates. Thus, JonesCorp would not be required to make a net payment to the swap counterparty. This answer choice is also incorrect.
C. The LIBOR term structure becomes downward sloping: If the LIBOR term structure becomes downward sloping, it means that interest rates for longer maturities are lower than those for shorter maturities. In this case, the floating rate payments that JonesCorp receives based on LIBOR would be lower than the fixed rate it has agreed to pay. As a result, JonesCorp would be required to make a net payment to the swap counterparty to compensate for the difference between the fixed rate and the lower floating rate. Therefore, this answer choice is correct.
To summarize, the correct answer is C. The LIBOR term structure becomes downward sloping. In this scenario, JonesCorp would be required to make a future net payment to the swap counterparty because the floating rate based on LIBOR would be lower than the fixed rate agreed upon in the swap.