Mazelee corp. intends to invest in a capital project in its local market. The Company raised Ksh 100 million through the issue of 12-year floating rate notes at 120 basis points over LIBOR, interest payable at six month intervals. Following a review of the current yield curve, Mary, the companys Finance Director has become concerned about the potential impact of rising LIBOR on the firms future cash flows. The loan now has 10 years to maturity. Mary has requested you, her deputy, to examine the choices that are now available to the firm and to recommend the best course of action. She comments that a swap is an obvious choice but that she would appreciate a briefing on the advantages and disadvantages of the alternative approaches to managing the companys interest rate risk and an estimate of the six monthly Value at Risk (VaR) if nothing is done. As part of your investigation you note that 10-year swap rates are quoted at 5.255.40. In estimating the VaR you note that the firm has a policy of 95% confidence level on its exposure to non-core risk and that the annual volatility of LIBOR is currently 150 basis points.

Required

1. Evaluate the alternative choices the company has for managing its interest rate exposure and recommend, with justification, the course of action the company should follow. (8 marks)

2. Estimate the six-monthly interest rate and the effective annual rate payable if a vanilla interest rate swap is agreed. (6 marks)

3. Briefly discuss the uses and limitations of Value at Risk (6 marks)