A bank holds a £5 million loan at a fixed rate of 2.5% per annum for three years, with semi-annual payments. The bank had originally funded this loan at a fixed rate, but because of recent changes in interest rate expectations, it has now decided to fund it at a floating rate. Although the terms of the loan to the borrower cannot be changed, the bank can convert the loan to a floating-rate loan by using a swap. The fixed rate on three-year swaps with semi-annual payments at LIBOR is 3.5% p.a. The assumption is that the number of days in a year is 360.

i. Explain how the bank could convert the fixed-rate loan to a floating-rate loan using the swap, also identifying the interest payments.?

ii. Will the effective floating rate on the loan be lower or higher than LIBOR? Justify your answer.

iii. Suppose that, given increased macroeconomic uncertainty, the bank would like to have the flexibility to terminate the swap at any time prior to the end of the three years. Describe the type of swaption that will achieve this goal.