FN450 Derivatives Assignment: Chapter 8 Please answer the following questions based on the material in Chapter 8.

Answer all assignment questions in complete sentences with full explanations and supporting details. Use the appropriate investing concepts and terms, but write everything in your own words. For problems involving math, show all work. 1. You would like to enter a swap for one barrel of oil per year for each of the next three years. The forward prices of oil for 1, 2, and 3 years are $50, $55, and $60, and the 1, 2, and 3-year interest rates are 2%, 2%, and 3%. a. Find the price of the prepaid swap.
50 / (1.02) = 49.02 55 / (1.02) ^2 = 52.86 60 / (1.03) ^3 = 54.91 Price of the swap $ 156.79

b. Verify that for a non-prepaid swap, the annual payments should be $54.89.

54.89 / (1.02) + 54.89 / (1.02) ^2 + 54.89 / (1.03) ^3 =

$ 156.80

c. Based on the $54.89 swap agreement, and assuming financial settlement, what happens if the price of oil in one year is $48? Be sure to state whether you are paying or receiving funds. 48 54.89 = -6.89, payment of $6.89 from buyer to counterparty d. What happens if the price of oil in two years is $80? 80 54.89 = 25.11, payment of $25.11 from counterparty to buyer e. Can you say for sure what your total net payments for oil and the swap will be each year? Explain. 5 / (1.02) + 5 / (1.02) ^2 + 5 / (1.03) ^3 = $ 14.28 The swap has this value because it allows the holder to pay $54.89 for oil that now has more value. 2. You have $400,000 in floating rate debt on which you make payments once per year. You would like to convert to a fixed rate. You and a swap counterparty agree to the reference interest rate 6%. a. At the end of the first year, the actual interest rate is 4%. Who pays whom, and how much? 6 4 = 2% or $8,000, I owe the counterparty. b. At the end of the second year, the actual interest rate is 10%. Who pays whom, and how much?

10 6 = 4% or $16,000, the counterparty pays me. c. Considering that when you first enter the swap, you will not know whether you will be paying or receiving money each year, nor how much the amount will be, why is the swap considered to be a way of hedging risk, instead of being an added risk? It is considered hedging because no matter if you are being paid or having to pay your net payment will be the same according to what was agreed upon with your counterparty. Whether or not you get paid or have to pay depends on the actual rate each year. Even though the rate can change each year you have already agreed upon a rate beforehand which allows you to hedge the risk of changing rates.

3. Consider the following prices for zero-coupon bonds: Year: Price: 1 2 3 4 5 0.9790 0.9594 0.9306 0.9074 0.8711

a. Find the fair reference rate for an interest rate swap covering years 1, 2, and 3.

(1-.9306)/(.979+.9594+.9306) =

2.42%

b. Find the fair reference rate for an interest rate swap that begins in year 3 and covers through year 5.

(.9594-.8711) / (.9306 + .9074 + .8711) =

3.26%

4. A U.S. firm has issued a 7% euro-denominated bond priced at 1000. The current exchange rate is $1.20/ and the firm could issue bonds in the U.S. at 5%. a. Find the face value of a bond denominated in dollars that would be equivalent to 1000, then find the annual coupon payments on that bond. 1000 * 1.2 = $1,200 face value of bond denominated in dollars 1,200 * .05 = $60 annual coupon payment b. What is exchanged at the end of each year under this swap agreement? Give specific amounts, being sure to state whether the firm is paying or receiving those amounts. Firm pays $70 per year and receives $1,000 at maturity, exactly offsetting the existing bond payments, and instead receives $60 per year and $1,200 at maturity.

5. You own 100 shares of XYZ stock. You would like to retain ownership of the stock so that you have voting rights at XYZ board meetings, but you would prefer to earn a market interest rate rather than

face the risk of the stock price. You enter a total return swap, in which you and the counterparty agree to LIBOR at the reference rate. Carefully explain how it is determined at the end of each year who pays whom and how much. As an example, suppose that in the first year, the return on XYZ stock is 8% (a loss) and LIBOR is 3%. The payments are determined by the difference between the returns. Since you agreed on the LIBOR rate your counterparty would have to pay you the 11% difference between the stock and LIBOR rates in order to get you to the agreed upon return of the LIBOR rate. If the stock went up 8% (gain) you would only be allowed to keep the LIBOR rate of 3% and pay the remaining 5% to your counterparty. Even though you still own the stock with the total return swap you agreed to receive the LIBOR rate meaning the difference between the stock and LIBOR rate is what is paid or received from your counterparty depending on which is higher the LIBOR rate or the rate of return on your stock. This is a great way to hedge against the risk of return on your stock and guarantee you the LIBOR rate, however if your stock has a higher return than the LIBOR rate you will owe that difference to your counterparty.