EFB344 Risk Management and Derivatives

Tutorial W9: FRAs and Swaps

Readings: Hull et al. (2014) Fundamentals of Futures and Options,

Ch. 4 and Ch. 7: 7.1 – 7.7

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General Questions:

Question 1

Consider an Australian dollar FRA where a company will receive a rate of 6% with annual
compounding, on a principal of $100 million over 1 year. The forward rate is 5%. With this
information and following the Australian FRA conventions,

a. Explain whether an investor seeking to hedge a 1 year future investment would enter into the
‘receive’ or ‘pay’ side of the FRA.

b. Following from a. show that the investor who hedges their future investment with the FRA
would earn the FRA rate on their future investment.

Question 2

A bank quotes an interest rate of 14% per annum with quarterly compounding. What is the equivalent
rate with a) continuous compounding, and b) annual compounding?

Question 3

Suppose that zero rates with continuous compounding are as follows:

Maturity (Months) Rate (% per annum)

3 8.0
6 8.2
9 8.4
12 8.5
15 8.6
18 8.7

Calculate 3 month forward interest rates for the second, third, fourth, fifth and sixth quarters.

Question 4
Assuming that zero rates are as in question 3 above, what is the value of a FRA that enables the holder
to earn 9.5% for a three-month period starting in one year on a principal of $1,000,000? The interest
rate is expressed with quarterly compounding.

Question 5

You observe the following bond prices in the market

Bond Face Value Time to Maturity Coupon Rate (S/A) Market Price

100 6 months 0 97.43

100 1 year 6% 100.41

100 1.5 years 5% 98.76

100 2 years 5% 98.00

Find the 6 month, 1 year, 1.5 year and 2 year zero rates.

Question 6

Companies A and B have been offered the following rates per annum on a $20 million five-year loan:

Fixed Rate Floating Rate

Company A 5.0% BBSW + 0.1%

Company B 6.4% BBSW + 0.6%

Company A requires a floating-rate loan: company B requires a fixed-rate loan. Design a swap that
will net a bank, acting as intermediary, 0.1% per annum and that will appear equally attractive to both
companies.
Question 7

A $100 million interest rate swap has a remaining life of 10 months. Under the terms of the swap, six-
month BBSW is exchanged for 7% per annum fixed (compounding semi-annually). The average of the
bid-offer rate being exchanged for six-month BBSW in swaps of all maturities is currently 5% per
annum with continuous compounding. The six-month BBSW rate was 4.6% per annum (semi-
annual)two months ago. What is the current value of the swap to the party paying floating? What is
the value to the party paying fixed?