Question
A) On the fixed income side, the fund has issued 500m 5 year bonds, semi-annual pay, floating rate notes with coupons equal to 180 day
A) On the fixed income side, the fund has issued 500m 5 year bonds, semi-annual pay, floating rate notes with coupons equal to 180 day LIBOR plus 30 basis points. Now, one year later, the risk manager is worried that the interest rates might rise over rest of tenor of the issue. Hence, the firm decide to go long into a 3 year payer swaption with a fixed rate of 2.5%, semi-annual pay, with N.P of 500m. For simplicity, assume that swap and FRN have the same settlement dates. At the swap initiation, 180 day LIBOR is at 3% and 360 day LIBOR is at 3.5%.
Required:
- Show the net settlement in 180 and 360 days? (6 marks)
- Show the firm the has effectively eliminated the uncertainty associated with FRN by entering into a swap? (4 marks)
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