5. (a) Using your own hypothetical examples, critically evaluate any two reasons why investors may use plain vanilla interest rate swaps. (8 marks) (b) Companies Alpha and Beta face the following interest rates (adjusted for the differential impact of taxes): Beta LIBOR+ 1.25% in750 US dollars (floating rate) Canadian dollars (fixed rate) Assume that Alpha wants to borrow U.S dollars at a floating rate of interest and Beta wants to borrow Canadian dollars at a fixed rate of interest. A financial institution is planning to arrange a swap and requires a 20-basis-point spread. If the swap is equally attractive to Alpha and B, write out a potential swap that generates this result. 3.0% 4.5% (6 marks) (c) A currency swap has a remaining life of 36 months. It involves exchanging interest at 2% on 40 million for interest at 1.5% on $28 million once a year Assume the term structure of interest rates in the UK and US is currently flat and that if the swap were negotiated today the interest rates exchanged would be 1.7% i sterling and 1.3% in dollars. All interest rates are quoted with annual compounding. The current S/E exchange rate is $1.25. What is the value of the swap to the party paying sterling? (8 marks) (d) Suppose that the risk-free zero curve in Canada is flat at 3% per annum with tinuous compounding and that defaults can occur half way through each year in a new 5-year Canadian sovereign credit default swap. Suppose that the recovery rate is 45% and the default probabilities each year conditional on no earlier default are 306. Estimate the credit default swap spread. Assume payments are made annually (11.3 marks)