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Markets

and Derivatives 2016/17

Seminar Problemset 3
The exercises in this problemset correspond to lectures of Part 2 of the course.
You do NOT have to hand in solutions to this problem set, but you are expected
to participate in the solution of these exercises during the seminar class on
November 8th.
1) A \$100M interest rate swap has a remaining life of 10 months. Under the
terms of the Swap, six-month LIBOR is exchanged for 12% per annum fixed
rate (semi-annual compounded). The six-month LIBOR rate was 9.6%
(semi-annually compounded) two months ago. What is the current value of
the swap to the party paying floating? Use a 10% continuously compounded
discount rate for all maturities

a. For the party paying the floating rate, value this swap in terms of bonds.
b. Repeat the valuation, valuing the swap in terms of Forward Rate
Agreements (FRA)

2) Companies A and B face the following interest rates:

US\$ (floating)

LIBOR+0.5%

B
LIBOR+1%
6.5%

Assume A wants to borrow US dollars at a floating rate and B wants to
borrow Canadian dollars at a fixed rate. A financial institution is planning to
arrange a swap and requires a 50 basis point spread. If the swap is equally
attractive to A and B, how do we have to set up the swap that A and B are
not carrying any exchange rate risk?

3) Companies with high credit risks are the ones that cannot access fixed-rate
markets directly. They are the companies that are most likely to be paying
fixed and receiving floating in an interest rate swap. Assume the statement
is true. Do you think this increases or decreases the risk of a financial
institutions swap portfolio? Assume that in general companies are most
likely to default when interest rates are high.

4) Alpha and Beta Companies can borrow for a five-year term at the following
rates:

Alpha

Beta

Aa

Baa

10.5%

12.0%

LIBOR

LIBOR + 1%

a. Calculate the quality spread differential (QSD).

b. Develop an interest rate swap in which both Alpha and Beta have an equal
cost savings in their borrowing costs. Assume Alpha desires floating-rate
debt and Beta desires fixed-rate debt. No swap bank is involved in this
transaction.
5)
Do problem 4 over again, this time assuming more realistically that a swap
bank is involved as an intermediary. Assume the swap bank is quoting five-year
dollar interest rate swaps at 10.7% - 10.8% against LIBOR flat.