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Question1
You are the treasurer of a company with a 4-year, $20 million FRN outstanding at
LIBOR. You are concerned about rising interest rates in the short term and would like to
refinance at a fixed rate for the next two years. A swap dealer arranges a 2-year plain
vanilla interest rate swap with annual payments in which you pay a fixed rate of 8.1%
and receive LIBOR. The counterparty receives 7.9% and pays LIBOR. Assume that the
counterparty also has fixed-rate debt outstanding at 8%. One-year LIBOR is currently
7%. Diagram and compute each partys net borrowing cost and first year cash flows.
Transaction diagram
8%
7.90%
LIBOR
LIBOR + 0.1%
Company B
Pay fixed
Receive fixed
Pay fixed
Net borrowing cost
Dealer
Pay fixed
Receive fixed
Receive variable
Pay variable
Profit
7.90%
8.10%
LIBOR
LIBOR
8.1 -7.9 = 0.2%
LIBOR
LIBOR
8.10%
8.10%
Cash flow:
Company A to Dealer = 7%-7.9%=0.9%
Receive 0.9%*20 m = $ 0.18 million
And to 3rd party Pay 8%*its Debt
Company B (you) to Dealer = 8.1%-7%=1.1%
Pay 1.1%*20 m = $ 0.22 million
And to 3rd party Pay 7%*20m = $ 1.4
million
Question2
A corporation enters into a $35 million notional principal interest rate swap. The swap
calls for the corporation to pay a fixed rate and receive a floating rate of LIBOR. The
payments will be made every 90 days for one year and will be based on the adjustment
factor 90/360. The term structure of LIBOR when the swap is initiated is as follows:
Determine the fixed rate on the swap and calculate the first net payment of the swap.
For each rate, we need to compute the present value (discount) factor (Zi).
Zj = 1/(1 + Sj)j
Day
Z90
Z180
Z270
Z360
= 1/(1+7%)90/360
= 1/(1+7.25%)180/360
= 1/(1+7.45%)270/360
= 1/(1+7.55%)360/360
= 0.983227588
= 0.965609099
= 0.947534835
= 0.929800093
Libor
Rate
90
7%
180
7.25%
270
7.45%
SFR
360
7.55%
Z
0.9832275
88
0.9656090
99
0.9475348
35
0.9298000
93
Floating payment
= $35,000,000 x 7.00% x 90/360 = $ 612,500
Then the Company has to paid = $ 642,250 - $ 612,500 = $ 29,750
Question 3
Suppose that the zero-coupon yield curve based on LIBOR is flat at 4% compounded
continuously. Compute the value of a three-year option on a five-year swap assuming
the swaption gives the holder the right to receive 4.2% fixed. Assume payments are
made semiannually (m = 2) and principal L is 100. Assume also that the volatility of the
forward rate on five-year swaps in three years is 30%.
d1
ln(F / RX ) 0.5 2T
; d2 d1 i ti
i T
Question 4
During the first six months of the year, yields on long-term government debt have fallen
about 100 basis points. You believe the decline in rates is over, and you are interested in
speculating on a rise in rates. You are, however, unwilling to assume much risk, so you
decide to do an intra market spread. Use the following information to construct a T-bond
futures spread on July 15, and determine the profit when the position is closed on
November 15.