= Answers to Questions and Problems 1. A trader buys a bond that pays an annual coupon based on LIBOR with a principal amount af $10 million. "The actual payment in each year depends om the level of LIBOR observed one year previously, The same trader simultaneously sets a $10 million dollar bond that pays fixed rate of 7 percent interest and also has an annua! coupon. Both bonds have a maturity of five years and are priced at par, The trader also enters 2 pay-fixed interes rate swap with annual payments, a tenor of five ¥eas, and notional principal of $10 mil lion. For the swap the fixed rate is 7 percent and the loaing rate is LIBOR. ‘The swap also pays in arrears ted with the bond, |A. Construct time line for each bond showing the payments associ FRN Time Line: stoo000 + po, roe, too, Lupo, UsoR stapinhoo —»stogonooa = Sijeuion «9080000 «$19 00n00 sm smo setors srn920 soon 5 sigsoaon 24ess TO QUESTIONS AN ponies 215, B, Construct atime line showing the net payments resulting Irom the two bonds. Bond Pott Tine ti eos, aos twos, vot eos sstastioo —s0peo9—loution = tontioo sino As * ¥ ¥ sun a . Construct a time line showing the payments for the swap. Pay-Fixed Swap Time Line sor, uso uno, LisoR, uso , ~sivarooo ——*singone0o —s9og0000 x Siaconba ——_—»$toova0 A A r 7 7 7 7] 7 ew v y smo on srmo00 sxag00 so0009 DD, Based on the «wo time lines from parts B and C, what conclusion can you draw regarding the relationship ‘neeween swaps and bond portfolios? A plain vanilla swap can be constructed or synthesized by 2 bond portfolio, This is the case because the ‘bond portfolio and the swap have identical cash Hows. This suggests thatthe prices of bonds can be used to salue swaps, and that swaps cane used to rsnsform eash flow patterns on bond portfolios. 2, Assume that today is December 17, 2003. A frm enters a plain vanilla interest rate swap asthe reeive-fixed pary ona swap with a tenor of one yea, quarterly payments athe end of the next four quarters, and a notional Principal of $25 million. Ac the same time, this fem buys a strip of Eurodollar futures for the next four eon- tracts, with 25 contracts per expiration, (Ignore daily setlement; in ther words, assume tha all fatures-related ‘ash flows occur atthe expiration ofthe Futures contract, whieh occurs at the end of each quarter) A present, 11 0, the LIBOR yield curve is fac at 8 percent, and the fixed rate onthe swap is also 8 percent. A. Complete the following table using our familiar L/BOR, notarion, Assume what the Eurodollar futures rate converges to LIBOR at expiration, (uarterNet Received Swap Cash low Net Long Futures Cash low ° ° ° 1 (a9 uBoRy» 25000000 (008 ~ usoR yt $25000000 2 (ons — UBOR 525000000 {08 — usoR,y4 » $2500n000 3 (00s ~uH0R 4525000000 {008 — uBR 25000000 4 (006 ~ UBORE 525000000 {aoe — usoR9y = 25000000216 cuarren21 sas: ecowodnc MUNYSS AND PRICING All ofthe futures contracts should be entered a 8 pereent, because the yield curve is fa The payofT on each futures depends on the deviation of spot LIBOR at expiration from the initial futures rate of 8 percent, With aly settlement being considered, the actual flows would have been the same on the futures, bur they would have been incurred piecemeal asthe futures approached expiration 1B. If his swap had been a determined-in-advance/ paid ‘om the swap? vance swap, what would be the payment at = ‘The payment wesld be 7p LIBOR, 7 C. What conclusion can you draw regarding the relationship between a plain vanilla interest rate swap and a strip of Eurodollar futures? A strip of Eurodolarfacues is very similar roan imerest rate swap. However, while they may be conceptually ‘very close, there ae important differences in the timing of eas lows, asthe table in parc A shows Asthe answer to part B shows, the Eurodollr strip is even claer tu a determine-in-advance/paid-in-advance swap. Exen then, the cash flow forthe futures and swap are not quite identical, When we consider daily sttement on the Fares, the equivalence is degraded even more. Silla Fusodollar stip and a plain vanilla swap ae very similar. 3. Consider a plain vanilla swap feom the poi of view of the pay-fixed counterpatty. The swap has a tenor of five years with annual payments, «notanal prineipal of $80 million, payments in arrears, » floating rate of| LLIBOR, and 2 fixed rate of 7 percent. Assume that the pay-Fixed counterparty buys a call option with an expiration date of two years. Ifthe cal i in-the-mones, it pays the observed LIBOR on that date minus 7 percent on a notional principal of $50 million. The pay-fxed patty also sells 2 similar put option: two-year expiration, $50 million notional prinipal. Ifthe put is in-the-mioney, the payofT equals 7 percent minus observed LIBOR times the notional principal. In cach ease, the rate is observed in (0 years, with the payment date actually occurring one year late. Beating in mind thar te rates observed i vear 2 determine the atual esh flow at year 3 on the swap, put a ell: A. Complete the following table showing the pay-fixed side of the swap, the long call, and the short put for the payment a year 3 asa function of LIOR oyerved at year 2 uso, Fue Net Swap Paymenh ong call Payot short Put Payot des $500au0+ 005 ssn009c00 ° ~ (06? ~ 095) $50,000.00 =~ si0acn | = = sion000 ‘500000 + 096 $sa000008 ° ~ (006 ~ 005) 50901000 = ssouon0 ssqo00 07 ~ $85onn00 + 007 s00nn00 = $0 0 ° 008 = S3smno00 + van §Saonne0 ——@o8 ocr) $s4000000 ° = ssonom sono 008 sso + 002 909000 (008-007) ssaan0000 ° = Siomo00 = siooaa00 1B, What docs this table show sbaut the relationship between a single swap payment and the call/put portfolio of options? A single payment on a plain vanilla interest rte stp is equivalent co a call/PU portfolio suitably adjusted 25 timing and notional principal. A pay-fxed paymem is equivalent to & long call/short put portfolio, ‘while «rective-fived payment is equivalent to a short eal/long pin prtfaio,‘Avene 10 quesTons avo paostens 217 (C. What does the table show about an entre swap and a possible portfolio of options? A plain vanilla interest rate swap can be replicated asa strip of eall/put portfolios, with each portflio corre sponding toa single payment, This forshadows the next chapter, which discusses caps (strips of interest rate calls), Nos (strips of interest rate puts), and collaes (strips of put/all portfolios). D. If the svap had been a reevive-ixed swap, what option position would have replicaod the swap payment at year 3 ‘The same options, but with a short call/long put portfolio, would be equivalent to the reeeive-fxed payment. tations ofthis 44. Explain how an interest rate swap can be analyzed asa strip of futures, What ace some i analysis? We have already noted that a swap may be regarded asa portfolio of forward contracts. A swap may also be thought of 26 a portfolio of forward coatracts, or FRAS. For example, a swap agreement with quarterly payments based on Eurodollar deposit rates is essentially similar toa strip of Eurodollar futures contract in which the furures maturities match the payment dates on the swap However, a strip of FRAs can exactly replicate the esh flows ofa swap, while strip of fuures eannot. The futures contracts involve day sette- ment cashflows, for instance, bucan FRA and asap de not. A strip of fucures is unlikely to have expiration dates thar exactly match the payment dates of a swap, paricuaely sines Eurodollar futures have just four expiration dates per year for the main contracts on the March, June, September, December cycle, Als, saps are generally paid in arrears, wheveas futures are put a6 they approach expiration through daily settlement ‘Today the following rates may be observed: FR Ay; = 0.0600; FRyy = 0.0595; FRAgy = 0.0592; FRAy42 = 0:0590; FRA,n15 = 0.0590; FRaisi5= 0.0588; FRA y= 0887, PRAy,24~ 0.0586, where the subscripts pertain to months. Consider plain vanilla swap with @ tenor of two Yeats, quarterly payments, and a notional principal of $10 million, ‘A, Compute the discount rates for each payment date on the swap Zyy= 1+ PRA A= 1 + 0.0800/4 = 1.01500 Zag = Zag 1+ PRAgg/4) = 1.015 (1+ 0,0595/4) = 1.030098, Zug Zap + PRAgy/A) = 1.030098 (1 + 0.0592/4) = 1.045345, Zaua™ Zag (I + FRA y/) = 1.045343 (1 + 0.0590/4) = 1.060762 Zaas™ Daya (+ PRA y/) 1.060762 (1 + 0.0590/4) = 1.076409 Zaye = Zags 1+ PRA 9/4) = LO7OHO9 (1 + 0.058874) = 1.092232 Zag, * Zogy (+ FRAyy/4) = 1.092232 1 + 0.0587/4) = 1.108260, Zang = Zany (I+ PRelysy/4) = 1.108260 (1 + 0.058677) = 1.124496 B, Fiad the SPR for this swap, FR Ay y/o. Mos 3 0 ni Faas srr= = For our swap, MON = 3, Desling withthe numerator and denominator separately, we have: 0.0600. 010595, 0.0592, 0.0590, NUMERATOR= +509 * {-axgoo8 * 7.045343 * 7.060762218 cwpren 21 wos: ecovowic Annus 0.0500 , 0.0588. , 00387 , 0.0586 ovsio9 * 92232 * TtaKzAd * T2456 = 039113 + 00s77 + 0.056632 + 0.055620 + 0054812 + 0053885 + 0.052966 + 0052112 = 0.42851 et yt 1 ~ Tsao * Tosoons * Toisas * To807es toy a Tonstos * Tos2a%2 * Troszs0 * T1296 = 0.985222 + 0.970781 + 0.956824 + 0.942719 + 0.929015 + 0.915856 + 0.902315 + 0.889287 = 7491519 spp =_NUMERATOR SER = DENOMINATOR ~ 7491319 oso14 . Find the APPROXSER for tis sa. (1+ APPROXSPRY? = T] (1+ FRAy sycnorsecaos 7 '=(1.0600°* (1.0595 (1.05922) (1.0890) (1.0590) (1.05882) (1.0587) (1.0586) = 1.121695, APPRONSER = 0.059100 D, Assume thatthe same swap is to be negorated as un off-market swap in which the receve-fived party will receive 7 percent. What payment atthe initiation of the swap will make the transaction a fair deal? ‘The swap will bea “fair deal” if the present values uf the wo sides of che swap are equal, We have just found that the SFR for the plain vanilla swap is less than 6 percent, If che swap i to be negotiated with a fined rate ‘of 7 percent, the feed rate payer will be paying too much. ‘To make the off-market swap a fai deal, the receve-fived party must make, and the pay-ixed party must receive, a payment of X. The present values of the payments made by the reccive-fived party, including our payment X, are FRAgy PRAy | PRA) | PRAyia PRAn Zon, PRA | PRA Zax Fae Zan an Za ae Zan” Fae i) For both ofthese terms, we have already found the quantities in parentheses in part B ofthe question, where swe found the SFR for the plain vsnila swap. They are equal to the NUMERATOR and DENOMINATOR ‘computed there. Therefor, the air desl will meer the condition LX + PART» NP 0442851 = PART NP > 0,07 x 7491519 From the statement of the question, we know: PART = 0.25 and NP = $10,000,000. Therefore, we have: X= 0.25 » $10,000,000 [0,67 (7.491319) ~ 0.442851] = $203,888, let y aa e Fn Zan + sre wpeoorx( b+ b+ ot parrenpxoar( + deg tg-¥5Rs o QUESTIONS AND PROBLEMS The receive-ixed party must pay the pay-Aived party $203,888 a de outset ofthe swap to make the of- marker swap a far deal, This $203,888 compensates the pay-fixed purty foe paying about | percent per annum more than the SFR on a plain vanilla swap, This makes sen intuitively, boeause the pay-fxed part is paying about percent over the SFR on $10,000,000 for each of two yeas, or something aver $100,000 per year 6. Today in the market you obscrve the following discount rates, where the subscripts indicate months Zu = 1020; Z9, = LTS, Za, 9 = LOS, 10976; 2, ys = 1.1193; Zp, p= F.1472; Za = 11685; Zo,24 = 1.1872. Compute all possible three-month FRA rates, 1.0240 = 1 + PR 9/4; PRM, = 4 0.0240 = 0.09600 In general, for FRAs to cover a fraction ofthe year equal to PART, where a> 0: Bie ‘Therefore, FRA, = (ZuulZs~ V) x4 = (1.0475 /1.0240 ~ 1) x4 = 0.091797 FRAG = (Zao! Zag 1) x4 © (107881 0475 ~ 1) 4 = 0.099284 FRAgy2 = Loyd Za ~ 1) 24 = (1,0976/1.0735 ~ 1) > 4 = 0.089800 PRAg. = Cas! Zos~ = (1.1193/1.0976 = 1) <4 = 0.079082 FRA 15 (Za Zas~ 1) 4 = (LIATR/LTI93 ~ 1) 4 = 0.099705 FRAsy y= 2au/ 2a V4 FRA y= (oy Zaay ~ V4 (LABT2/1. 1655 (1,1655/1.1472 ~ 1) <4 = 0.063808 1) x4 0077 [A zoro-coupon swap isa swap in which the fixed rate i 2c. Instead of making periodic coupon payments, the fixed rate payer makes 2 single large payment a the termination ofthe swap. Zero-coupon swaps may be cither interest rate seaps in any currency (with no exchange of principal) or foreign currency swaps (with the customary exchange of principal). Using one zero-coupon swap (either an interest rate or a foreign currency swap), and one bond of any type, construct a synthetic zero-coupon bond that pays German ‘marks, and has a principal amount of DM 100 million and a maturity of fv yeats. "The German mark yield curve is fa at 6.3 percent, Assume annual payments throughout, A. Find the cash flows associated with the jerman roa draw a ime line for this instrument ‘With a at yield curve at 6.3 percent and annus! ompounding, the five-year zru-eoupon factor is (1.063 = 1.387270, A zero-coupon bond to pay DM 100,000,000 in ive Yeats would cost DM 73,677,296 Zero-Coupon OM Bond: ‘out onsons00 usar220 curren 21 suas: EcowOMC AAI AKO PRICE B, Draw time lines forthe two i rumsents that will replicate the German 2er0, showing the cash flow amounts a each tins, under the assumption of constant interest eats, DM FRN: ons 670 Destin Seer Opa A> DM TSTI6 ero-Coupon Receive-Fixed DM Interest Rate Swap: Dagson70¢ Duasinsiy paging OM 4eALSTD OM Agung gp . State the transuetions necessary to replicate the German zero, Replicating the DM zero-coupon bond can be accomplished hy buying 2 DM FRN with a maturity of five years and with an initial outlay of DM 73,677,296, At present rates, the annual coupon payment would be DM 4,641,670. Also, one would enter a DM zero-coupon interest rate swap to receive a fixed payment atthe termination of the swap inthe amount of DM 26,322,704 and to make five floating rate payments at annual interval. At present rates, the annual floating payment would be DM 4,641,670, 1D. Explain how the replication you have ercated still works if interest rates change If rates change, the floating payments will vary on both the FRN and the zero-coupon intrest rate swap. However, they will stil be the same quantity on the two instruments and will stil exactly offset each other. erefore, the replication will be maintained with a net outflow at ¢ = 0 of DM 72,677,296 and a ct inflow 5 of EM 100,000,000, 8, Consider an already existing fined-for-fted foreign currency swap that was negotiated at an exchange rate of S1= ¥1)} wich a notional principal of $100 milion ~ $11.1 billion. The swap has quarterly payments and a remaining tenor of one year. The dollar fixed rate is 7 percent, and the yen fixed rate is 6.8 percent. Assume that the following foreign exchange rates are observed now, where ,yPX,, isthe value ofthe dolar in terms fof yen for a contract initiated at month x with delivery ar month y-'y yPXo, 5 = 115; g, vPXq, 6 = 17; avPXo.9 = 11954. ¥PXan = 120.ANSWERS TO QUESTIONS AND PROBLEMS 221 A. Prepare a time line showing the remaining payments on the swap from the point of view of the dollar payer sara ier 7on00 viata ex7on00 F iF G 2 Monts 9750000 suse siasage 1780000 BB. Calculate the present value of the swap from the point of view of the dollar payer if che following US interest ates hold: PRA, 1 = 0.0535; FRA, « = 0.0640; PRA,» = 0.0642; FRAy yx = 0.0645, Given the forward exchange tates sated above, the dollar Yalu of each of the four yen payments is Payment: Vea 20000075 = s1st0870 Payment 2 ¥68 700000717 = §)612821 Payment: veg 700000719 = $1585.78 Payent ea, 700000/20 = 81572500 The net dollar payments from the point of view ofthe dollar payer are: Nar Payoest = $1640870 = $1730000 = -509)30 | NerPeyment 2: = sisizan ~ 51750900 = -S157,08 | Net Peyment : = Si5i6.1¢ ~ $1.7s0000 = -s164786 Net Payment a: = $1572.50 ~ §1.750000 = -$172800 The discount rates are 28 follows Zus= 1 + 065M = 1015875 Zea 1oise75 (1+ 006404) = 03219 1052129 (1 + 00642} = 1088605 0¥8695 (1 + 095A) ~ 163605 fan From the point of view ofthe dolar payer, the present value (PI’) of the semaining swap commitment is $109,130 _ $137,179 _ $164,286 _ $177,500 To1s475 1032129 1.048995 ~ 1.068008 $107,425 ~ $132,909 ~ $156,658 ~ $166,572 ~ $563,564 PY C. How does the solution ofthis problem relate tobe interest rate parity theorem? ‘The solution evalusted the swap from the point of view of the US dollar payer. fn doing sa each yen eash flow was converted into dollars ache foreign exchange forward rate corresponding tothe timing of the yen flow, These converted dollars were then discounted a the US dollar rae, In essence, the combination ofthe US interest rate withthe forward foreign ange rate takes account ofthe inerest rate party berveen the dollar and the yen. The solution did not need to cantront the yen interest rates discely, because they were cffecively considered by using the US interest rate and the forward foreign evehange rates. 9, Today you observe the flowing US interest rates: PR Ay, = 0.0650; FRA, « = 0.0655; FRA, » = 0.065%; Ry, = 0.0661, where the subseripts pertain to months. Consider a plain vanilla interest rate swap with222 _cowvan 21 snes: economic AMAUIIS AND PRONE {quarterly payments and 4 tenor of one year with a notional principal of $50 million and a zero-cost collar ‘hat parallel cis swap, having four payments and a remaining life of one yea, with a notional principal of {$50 millon, The collar has a common strike rate of 6.5 percent forthe pur (floor) and the eal (cap). ‘A. Without computation, determine whether the collar i arly prived. Explain ‘The collar cannot be fairly priced, since the strike rate is 6.50 petoent, the price ofthe collar is zero, and the term structure lies above that rate. Because rites start at 6.5 percent and rise from ehere, the SFR must exceed 6.50 percent, and the zero-costenlarshoull havea strike rate that equals the SFR. B, Find the SFR fora plain vanilla swap. "The discount rates areas follows: 4 (1.065074 » 1.016250 Za 1.016250 (1 + 0,0685/4) = 1.032891 Za ® 1.082891 (1 + 0.0659/4) = 1.049908 |L0s9yge (1 + 0.0661/4) = 1.067258 Next, we apply Equation 20.5, ercatng the numerator and denominator separately for convenience: 0.0650, 0.0655, 0.0659, _O.066t Tons2s0 * 7.032891 * 1.0s9908 * 7.067258 NUMERATOR = 0.252076 sq16t1 po 099908 * 1.067258 . Explain an arbitrage ssutegy based om the facts presented, being sure to state the transactions you would. rate to exploic the arbitrage Along call/short put option portfolio with both options having a common strike rate pays (LIBOR ~ strike rate) x notional principal. A plain vanilla pay-fied terest rate swap pays (LIBOR ~ SFR) x notional prin- pal. These values would require adjustment for snaps with payment intervals other than one year. In our problem, the common strike rate is 6.5 pereent, che SFR is 65617 percent, and payments occur quarterly. It we buy the zero-cost collar with 2 strike rate uf 6.5 percent and sell the pay-Gxed swap with an SFR of 6.5617 percent, our cost will be zero. (Selling a pay-fived swap is equivalent to entering eceive-ixed swap.) ‘The payoff on a single date will be as follows: ola (UBORY ~ 00858) x $s0.02R000 Beceve Fed Shap (0065674 ~ UIBOR) x $50000000 Combined Postion (0.056174 — 00858) x $59000000 = $771.50, ‘Therefore, this arbitrage seategy wil yield four inlows of $7,712.50 with no outflows. D. Compute the present value of your arbitage transaetions $912.50 , $7,712.50 , $7,71250 , $7,712.50 T0160 Towgo0s * 1 p67238 $29,628.43, 105289) 10, For a fairly priced plain vanilla swap vvth annual payments and a tenor of five years, the Fixed rate 36 6.44 percent. The yield curve is Mat. You also ate avare of two bonds avaiable in the markerplace, cach with annual coupon payments and maturities of five years ‘The firs is coupon bond with a coupon rate af 825 percent, The second is an FRN paying LIBOR + 2 percent, Assume zero default risk fr all instrumentsquesnons ano Prostens 223 A. Without comput ian, bus by inspecting te information given, which bond should be Worth more? With a lat yield curve, all FRA rates and discount rates will be equal ithe fairly priced swap fied rate of 6.44 percent. The FRN will, therefore, pay 8-44 percent, soit should be worth more chan the coupon bond paying 8.25 percent. B. Compute the no-atbitrage price difference berween the two bonds, ‘Assuming 4 par value of 100 on both bons, the FRN will pay 844 ~ 8.25 = 0,19 more each period “Therefore, the price differential should be equal tthe presem value of those lows, discounted atthe rate of 6.44 percent 019, 019, 019 019 188 * 0648 * 06H * Toot Pv=} 0.790859 Explain what arbitrage transactions you would entee ithe price difference between the bonds were 6 percent fof par. (Assume that the truly more valuable bond is priced higher than the truly less valuable bond, but the price difference is 6 percent instead of the no-arbitrage price difference you Townd in part B of this, question.) Draw a time line for each instrument assuming a par value of 100, Hint: You will need a yhied inarwment, some kind of interest rate swap, (0 ensure thar the transaetion isan asbitrage opportunity rather than speculation “The price difference should be 0.79 percent of pus, nt 6 percent. Therefore, if the FRN is priced so much higher than the coupon bond, we ean ereate an arbitrage opportanity by selling the overpriced instrument and buying the underpriced one. This requires selling the FRN and buying the enapon bond, Doing only this leaves a rsk exposure and is not arbteage, however Instead, the asbitrageur should: sll the FRN, buy the coupon ond, and initiate a pay-fixed plain vanilla Ingres rate swap, as shown belo, in a diagram assuming pat values of 100 on exch instrument Sell FRN: LUBOR 28 UBORY 7% BOR 2H OR 8 100+ LOR + 26 ‘Buy Coupon Bond: 229% 29% a6 nase oo + 820%224 curren 21 swe: ecowonc ANAYSS An ORIEN Initiate Pay-Fixed Sway on 20% uso soe ‘wo “The prices of the bonds are unknown, but the price ifferenee is 6 percent of par by assumption, so there is 4 net inflow of 6 percent of par at r= 0. At each coupon date, the net cash flow i: -LIBOR ~ 2% + 8.25% + LIBOR ~ 6.44% = —0.19% [As we have already seen, the present value of those five coupon flows is 0.790859 percent of par. At maturity of the bonds, 100 percent of par is due on the FRN and 100 percent of paris received on the coupon bond for amet zero payment. Therefore, the arbitrage has a present value af 6 percent of par feom the price differ cntial ofthe bonds, less 0.790859 percent of par for the coupon outflows. Also, this is an arbitrage because all uncertainty has been eliminated with respect to interest rates. 1. Consider two term structure environments, onc in which the yield curve rises and one in which the yield carve falls by the same amount, as shown in the rable below Marty (odbc pertain to years) FRARates Environment #1 FRA ates Environment #2 Fay ‘00 00600 Pea oso seo FR 0620 ose Fea 80630 00520 Fis 40 0560 AA, Fora plain vanilla interest rate sap with a five-year tenor, annual payments made in arrears, and a notional principal of $30 million, find che SFR for ths swap in each yield curve environment The discount rates are a follows: Environment #1 y= 106 2 16 tao = w24660 Zap = NMED 1060 = 194589, Zea~ 1B8589% 10650 = 1.263685 Zog= 1268655 10640 ~ 1350092 Environment #2 Zy= 106 Zu > 106 10380 1122540 Yas = 112540 10500 ~ 30647 Ziq = LEA 0570 1255548 Zag = 125550» seo = 1525642ANSWERS TO QUESTONS Avo Pontes 225 For the wo enviconments, the SFR ar: 9.0600 0.0610, 00620, O.n630_ 106 124660.” 1.194389 * 1,269 6.0640 22 0.061879 194389 "1.269655 * 1.350892 coe ty +t 06 * TaD * 1 195RaH * 1369695 * TURE 9600 , 0.0590, 0ns80 | o.0s70_ 0.0560 196" T.1225e0" Lisios7 ” 123533" 1325640 T 1 i T 106 * 112250 * Tiare?” TassHs * Taasot oss112 1B Find the prescnt value of each payment frum the point of view of the pay-fixed party in each environment. Find che um of the present valus ofthe payments in each envionment. Present Valu of Pay Fned Cash Flows-Environment #1 ‘Amount ‘Tero-Coupon Factor Present Value (006179 + 006)» Soanqaea = ~$9§57072 106 “sume (Costes + ona «sSaann000 = —59537072 4660 “pyaar (Cagsisa + 00820» sin00300 = $5680.00 19689 Sass! (Caosirs + ones) x ssuconoe = $3.2928 15638 2548155, (Costes + oneto)» SSatenon ~ $65.2928 1330802 acne Present Vale of Pay Fed Csh lows-Envronment #2 ‘mount ‘ero-Coupon Factor Preven ale (Caosaia + 008)» soomo00 = $66%789 106 sania) Goossi2 + 00850 x sagcoumn = 2564893 hazase 25,5098 (aoser2 + 00580)» ssaec0000 = “3555211 agnsar sun48 (oosar2 + 0051) §sqa0amn0 ~ $5352) lasses 2656812 aoser2 + 00560» ssago0000 = -565352 12s ares “The present values necessarily sum ro zero in each environment. CC. Evaluate che defile risk on these wo swaps from the point of view ofa swap bank in which the swap bank pays fixed assuming a relatively stable yield curve envirunment, {As with any furly priced plain vanilla swap, che present value ofall the rayments is ero when the swap is initiated. However, the pattcn of postive and negative present value payments ie quite different. From the point of view ofthe pay-ixed party, che positive presen value payments oocer later in Environment #1 and cali in Environment #2. This suggests that Environment #1 is riskier for «pay-fived party, because the pay-fixed party expects to lose on the early payments and make it up on the ater. If the pay-fined party suffers 4 defaule after two payments in Environment #1, for example, he never gets any postive present ‘value payments. This contrasts markedly with Envivonmenc #2, . Explain how any observed difference in default risk from the point of view of the bank might affect che bank’ pricing ofthe swap. Arising yield curve (Environment #1) exposes a pay-tted party to greater default risk ghana falling yild cure environment, because of the timing of positive and negative present value cash flows in each situa ion. Therefore, we might expect a swap dealer ro demand slightly more favorable terms to take the ay-fixed side of a swap ina rising yield curve environment Note: The remaining questions all use the same interest rate data, the same foreign exchange data, the same notional principal, and the same tenor.Interest Rote Dota: Problem 12 Feveign Exchange Data: raber 13 Sswop Terms: Semiannval payments; $109000,000 = ¥13,350000,00 notional principal Tenor: years 12 ‘The following data pertain co US and Japanese interest ates over the next five years for semiannual periods Complete the Following tables, ‘Maturity Semianoual Porods) _Ammalized Par ied __‘Tero-Coupon Factor Forward Rate Facor 1 08r700 aseso00 asesoo0| 2 se504 ess sion 5 ase? aries asssea7t a orm osaon6s2 vassen 5 ome oewrasea assaass ‘ ores aes lasezarss 7 ares Nes aseesst 4 orsas samseeo lass 9 ars 1 ssa384 aseoe89 © ures warns snes Maturity Semiannal Periods) Annual Forward Rate Factor Hl ‘oot? o80 voRess0 2 e302 oes2198 155096 3 9828 ansaoros tanesers 4 sar ona nasa 5 ‘sores hisses Longest ‘ sis tags65007 tm20297 7 o0s2546 Lisei0s ons2297 ® 0587 asi nese ° ssi 1 sn082 asses » 055856 oressar earesa51 ‘Values for these tables were found by applying the bootstrapping method, 13, Find the foreign exchange rates between the US dollar and the Japanese ¥en for the next ten semiannual periods consistent with the interest rates of problem 12, and eomplete the following table. Dla/Yen Exchange Rates ‘Matrty (Semianoal Periods) Sperven _Yenpers 0 ‘ouoms06e 1850000 1 orséita east 2 coresise §——sh052725 3 oom ssin96 4 oorraen 18358556 5 oomss §—rs8s6r é ‘asses? © eum) 7 ‘owrsenes —aS00729¢ a ooe0se7 esse 9 nooaisss ——PssA86 0 eztog —_7asse26, sis 10 caONS AND PROMLEMS 227 Given the spor exchange rates and the term structures for the io countries, the forward exchange rates ‘of the dollar versus the yen san be found by applying the interest rae parity theorem, As an example, we ‘compute the value of the dollar in terms ef yen for & horizon of 3.5 years (7 semiannual periods). From Equation 21.1, we have La PX Te 1X bX 7 In terms of our example, we have Ze = the Fpesiod zevecoupon lator forthe United States = 128152127 | evr = the spt exchange rate = 1585, 2.1 = the 7-petiod Zeo-coupon factor for apan = ‘19976103 1 29Xcr= the unknown foreign exchange forward ate = 1250022885 ‘The table shows all ofthe resulting calculations. Based on the US rate of problem 12, find the SPR for a plain vanilla US interest rate swap witha tenor of five years, semiannual payments, ad a notional prineipal of $10,000,000. Fora plain vanilla interest rate swap, the SER is gives by Eyuation 21.13 FRA yn as uO’ ya Pn nox “The following table shows the intermediate computations: US Rates Maturity fSemiannua Periods) Zeo-Coupon Facer das) Forward ate FRA, FRA, lar . 388000 eras osssso0 osama 2 a6s6945 sap asessr9e s240529 3 han668 snare osssen7 sais 4 ons gnorsiz seen? nsie369 5 aera oga.seit anssin's ‘02385004 « ss on2s201 oars aon 7 vaaisanr o7soess onsns3¢ wrens 8 17880 7504802 ons725 39557 5 nessa a76s0) ac0s89 onesies 0 \aa7ans oes oases onsoxs sums 20882 0957408 For the pin vanilla swap, che semiannual SPR = 0,29957408/0,828777582 = 0,03614650, so the annualied SFR equals 2 0,08618630 = 0,07229300. Note also tha the SFR on the swap will equal che coupon rate on ‘fixed coupon bond of the same matusty that trades at par From the completed table of problem 12, that rate is 0.072293, Based on the Japanese rates of problem 12, find the SFR for a plain vail Japanese interest rate swap with 4 tenor of five yest & notional prineipal of ¥13,350,000 (80, and semiannval payments. ‘The SPR on whe swap will equal the voupon rate on a Fixed Coupon bond of the same maturity thar trades a par. From the cumpleted ble of problem 12, chat ates 0.053356, It can also be computed direty as illus- trated for the US swap in the preceding ptoblem. Complete the following tables, based un the US and Japanese interest rates of problem 12, the foreign exchange rates of question 13, and the SFRs computed in questions 14 sed 15. The following letters correspond to column labels in the tables,Db Cash flows on a US semiannual coupon hond with 3 five-year maturity, a par value of $100,000,000, which trades a par ‘The cash flows consistent with the term structure of problem 12 fora semiannual US dollar floating rate ‘bond with a par value of $100,000,000 and a maturity of five years The cash lows on the receive-fixed side ofthe US dollar interest rate swap computed in question 14 ‘The cash flows consistent with che term strueture on the pay-flnating side of che US dolla intrest rate ‘swap computed in question 14 ‘The cash flows on a Japanese semiannual coupon bond with a five-year maturity, a par value of '¥13,350,000,000, whieh trades at par ‘The cash ows consistent wich the cerm seucture of problem 12 on a semanneal Japanese yen floating rate ‘bond with par value of ¥13,350,000,000 and a maturity of five years ‘The cashflows on the pay-fived side ofthe Japanese yen interest rate swap computed in question 15, ‘The zash flows on the pay-floating de of the Japanese yen interest rate swap computed in question 15, US instruments € D 8 Receivefited Pay leting Maturity (Semanal Periods) SeIFRN Interest Rate Swap Interest Rate Swap ° =sionome00 ——_siaaan60 % % 1 394650 3383000 4880 332000 2 630 540874 e680 4885150 5 ses50 ~3s8820 a14880 35598 4 0050 sesni7 setees0 “3en.r0 5 seineso 3807085, sesso 350700 6 350 sanziss sesso anys ? sqeso— —S20854 sansa 32056 8 eso ses7306 Sess0 3157964 9 soieeso—~Rane9 saesso ~is0895 » vossisso 05,7605 sanss0 srt Preset Yue ol Cash Fos ° 0 sasasra08 ~s98s1808 Japanese struments « " e F ReceiveFred Pay lating Maturity (Seniannwal Periods) Buy Semlanoual Sond SelFRN Interest Rate Swap Interest Rat Swap ° ‘isssaanno0 15350000000 0 0 1 sesIsis00 372589800 356151500 32585400 2 65/300 —S35765—90 3865300 335785050 3 ee er) ~ss.580730 4 35651300 —349)62500 386181300 =a 0200 5 Seis 357286080 396151300 357286080 ‘ 3611300 376765700 39651300 37676300, 7 Sais —39n/s5900 ——3sgns.300 35093000 a 35611300 386759190 396151300 306735150, a 36130 35565740 396)51300 355697400 » Ismasiso0 — —1y7asen6sO 55151300 ~3ea30080 Present of Cah lone ° © Yeossa0552 ——_Yscon99852‘uses To questions axo prowteus 229 For the lating instruments, the cash Sess consistent with the term structure equals the forward rate times ‘the notional principal, being eareful to adjust the floating rate for the perindicty of the swap payments, We already have che semiannual FRFS in the table for problem 12. So, using those forward rates and the notional ‘principal of $10,000,000, the following table gives the payments va the US dollar PRN: Us Rates Maturity (Semiannul Periods) Forward Rate RA, .y Floating Payment FRA,» NP f ‘8885000 358500 2 aseeae 3.466794 3 usss577 sssaan 4 oxen ses270 5 as5er5 35785 6 oons i227 7 sez598 anasoa a noses S736 9 seeot99 560998 snes a7i6s75 For the floating rate payments on the Japanese hond, the Japanese forward sates are used, along with the notional principal of ¥13,350,000,000 apanese Rates ‘Maturity (Semionnoa Periods) Forward Rate FRA, , Floating Payment FRA, <= MP . oonsas0 238275 2 oosi5005 55782686 3 asses sieran 4 consis86 synione 5 cnsrest sstasisat 5 zan57 6768299 7 oman 30195398 ® cuca se7s0677 3 onsseiae 355084798 0 n7es31 0904705 "Note thatthe presen values ofthe two sides ofthe sup are the same, as they mus he for fairly peiced swaps Based on the tables ofthe preceding question, explain how a US dollar plain vanilla receive-fixed interest rate ‘swap is equivalent co a portaio of bonds. Show how to replicate the swup position with a bond portfolio, [As the fist table in question 16 shows, if we buy the semiannual bond aad sell the FRI, the resulting cash flows ae identical to the eish flows om the receive-fixed swap Explain che transactions necessary 0 replicate a US dollar plin vanilla eceive-fxed swap as a portflio of FRAs, ‘An interest rate swap is a portfolio of off-marker PRAS, ‘To replicate rhe receive-ixed swap, one would enter 10 off-market FRAS. In each, one would contrat to recive $3,614,650 and to pay the forward rate times the half-year periodicity of the swap payments, times the notinal principal. ‘The Mloating rate payments implied by the term structure appear in column D of the table in problem 36 [Based on the previous calculations, complete the following tables detailing the cash fous for @ fixed for-fxed currency swap. What is the expected present value benefit o loss onthe periodic payments fa the dolla payer? What isthe expected present value benefit or loss on the reevchange of prineipal for the dollar