For this question you may use diagrams and illustrative data where appropriate.

a). A (non-financial) corporate has a 2 year bank loan of $10m which pays 6 month LIBOR+100bps. Current LIBOR rates are 3% pa.

Show how the corporate can use an interest rate swap, (with swap rate sp = 3.5%) to remove interest rate risk.

If interest rates turn out to be 2% pa and 4% pa (respectively) on the next two reset dates, what is the outcome for the corporate, with and without the swap?

b). Explain how a 10 year interest rate swap (with semi-annual payments) can be priced; why the (market) value of the swap changes over time, and why the change in value depends mainly on the fixed leg of the swap.