As a pension fund manager, you anticipate that you have to pay out 8 percent on $100 million for the next five years. The payment is made semi-annually. You currently hold $100 million of floating-rate note that pays LIBOR + 0.5 percent.  What is your potential risk?

To reduce your risk, you arrange a swap with a dealer who agree to pay you 7.55 percent fixed rate, while you pay him LIBOR. The swap payment is made semi-annually as well. Determine if you have sufficient cash flow to pension fund holder. Justify your answer.

 

A hedge fund is currently engaged in a plain vanilla interest rate swap with a company named BlueTrade. Under the terms of the swap, the hedge fund receives six-month LIBOR and pay 5 percent per annum on a principle of $100 million for five years. Payments are made every 6 months at rear.  Assume that the interest rates start to soar after two years and BlueTrade defaults on the seventh payment date when the LIBOR rate is 8 percent for all maturities (with semi-annual compounding). The 6-months LIBOR rate 6-months ago is 7.5 percent. 

What is the loss to the hedge fund?