Analyze a two-year swap agreement to exchange LIBOR for fixed-rate payments on a $100 million notional principal. The first payment will be made in one year; the second in two years. You have the following information on LIBOR rates: One-year spot rate is 4% per year. Forward rate in the second year is 6% per year.

1. What must be the annualized two-year spot LIBOR rate?

2. Find the floating-rate payments to be made.

3. Find the present value of the floating-rate payments.

4. Find the fixed rate that would price the swap correctly.

5. Now suppose that at T=1, just after the first payments were made, interest rate over year two turns out to be 7% per year (instead of 6% originally estimated). Which party is at a loss now: the one making the fixed payments, or the one making the floating payments?

6. Which party faces credit risk in part e?