An investor has purchased a floating-rate security with a 5-year maturity. The coupon formula for the floater is 6-month LIBOR plus 150 basis points and the interest payments are made semi-annually. The floater is non-callable. At the time of purchase, 6-month LIBOR is 5.5%. The investor borrowed the funds to purchase the floater by issuing a 5-year note at par value with a fixed coupon rate of 6.5%. Suppose the 5-year swap rate is 5.6% and the frequency of the payments is semi-annual. (12 marks)

1) Ignoring credit risk, what is the risk that this investor faces? (2 marks)

2) Explain how the investor can enter into a 5-year interest rate swap (in which one party pays the swap rate in exchange for 6-month LIBOR) to offset this risk and show the annual income spread the investor can lock-in using the swap contract. (10 marks)