A finance companys main asset is a 1-year loan of $100 million to a MNC. On its 1-year loan, the company earns the beginning of the year prime rate + 4%. The beginning of the first year prime rate is 6% per annum. Suppose that the finance company has financed this loan by raising $100 million through the issuance of a 5-year bond, which pays annually interest at the rate of 7%.

(i) What is the net interest income of the finance company in the first year? (1 mark)

(ii) What is the type of risk the finance company is facing in the subsequent 4 years? (2 marks)

Consider now an interest rate swap with the following characteristics:

• Notional principal = $100 million

• Term = 5 year

• One party will pay to the other party 9% fixed rate per annum and will receive the beginning of the year prime rate + 3%

• Payments = Annual

  Suppose the finance company wants to hedge against the interest rate in its own business by engaging in the above interest rate swap. (iii) Will it be a floating rate payer or floating rate receiver in the swap? (2 marks)

  (iv) If the finance company engages in the interest rate swap, what will be resulting interest income of the finance company in each year during the term of the swap?

  (4 marks)