This assignment is an exercise in simple derivative valuation. Skywalker is considering using derivative contracts in 2012 to hedge interest rate risk. However, before entering into any derivative contract agreements, the management of Skywalker wishes to better understand how the values of derivative financial instruments fluctuate.

For 2012, Skywalker is considering converting $600 of its long-term debt into 3-month renewable debt; by so doing, Skywalker will be able to receive various preferential privileges from its lender. However, Skywalker doesn’t want to bear the associated interest rate risk that would arise from the interest rate on the debt being reset at the prevailing market interest rate every three months as the loan is renewed. As a result, Skywalker has inquired about entering into an interest rate swap with another financial institution. The terms of the swap would be as follows: loan amount, $600; swap interest rate, 8%.

Skywalker would pay a fixed amount of $12 ($600 × 0.08 × 3/12) to the financial institution each quarter; in exchange, Skywalker would receive a variable amount equal to $600 multiplied by the current market interest rate (for a 3-month period). This is called a pay-fixed, receive-variable swap. Skywalker could then use the variable amount received to pay the variable interest amount on its 3-month renewable loan.

In practice, the swap will be settled by Skywalker’s paying an amount equal to [$600 × (0.08 –Market interest rate) × 3/12] when interest rates are below 8% and receiving the same amount when interest rates are above 8%.

The financial staff at Skywalker have done some research on the historical behavior of interest rates and have prepared the table at the left. The data in this table mean that if, for example, the current market interest rate is 8.0%, the probability that the market interest rate will still be 8.0% in three months is 30%. In addition, there is a 5% probability that the market rate will increase to 8.3% in three months, and a 3% probability that the market rate will decrease to 7.6% in three months.

Using these data, construct a spreadsheet to answer the following questions:
1. What is the value of the pay-fixed, receive-variable swap contract to Skywalker if there are three months remaining in the contract term and the current market interest rate is 8.0%? Be sure to indicate whether the swap contract is an asset or a liability for Skywalker.
2. Repeat (1) using the following assumptions about the current market interest rate: (a) 7.2%, (b) 8.1%, and (c) 9.0%
3. Comment on the relative sizes of the fair values of the derivative contract and \the notional value of the contract.