PROBLEM SET 07

SWAPS

AND INTEREST RATE DERIVATIVES

1.Assume that you are a swap dealer and have just acted as a counterparty in an interest rate swap. The

notional principal for the swap was $7.5 million and you are now obligated to make five annual

payments of 8% interest. The floating rate that you will receive annually is LIBOR + 2%.

(a.) If the LIBOR is 6.2 % and does not change over the next 5 years, what will be your annual net inflow?

(b.) What is the net present value of your swap agreement a t a discount rate of 8 %?

(c.) If the floating rate stays the same for the first two years and then falls by 1.5%, what will be your net

payments for the five years? Calculate the present value of the cash flows at a discount rate of 8%.

2.A swap agreement covers a 5-year period and involves annual interest payments on a JPY1 million

principal amount. Party A agrees to pay a fixed rate of 10% to Party B; while Party B agrees to pay a floating rate of LIB

OR + 2% to Party A. The LIBOR is 9% at the time of the first payment. What is the net payment between the two interest obligations?

3.Assume that the current spot rate for the Swiss franc is SF 1.5/$, the US interest rate is 9%, and the Swiss interest rate is 8%. Firm X wishes to exchange 30

million Swiss francs for dollars. In return for these Swiss francs, Firm Y would pay $20 million to Firm X at the initiation of the swap. The term of the swap is three

years and the two firms will make annual interest payments. If the spot rate at the end of year 1 changes to SF1.7/$, what is the net payment for year 1?

4.Two counterparties agree to enter a foreign currency swap between American dollars and Swiss francs. One dollar is currently worth 1.4 francs. The American dollar payer will provide $500,000. The interest rate on the dollar is 9%, and the Swiss franc rate is 8% The swap calls for a life of three years with annual payments.

(a.) How much will the provider of the dollar pay at the outset?

(b.) If the interest rates do not change, what is the annual dollar interest payment for the foreign borrower of dollars?

(c.)If a net payment is recorded for interest in year one and exchange rates do not change, what will be the net payment?

(d.) What will be the total payment in francs by the borrower of dollars for year 3?

(e.) What will be the total payment in dollars by the borrower of francs for year 3?

5. A mortgage company (Party E) has just lent $1 million for five years at 12% with annual payments, and it pays a deposit rate that equals LIBOR + 1%

. With these rates, the company would lose money if LIBOR exceeds 11% . This vulnerability prompts the mortgage company to enter an interest rate swap with Party

F. This swap agreement covers a five-year period and involves annual interest payments on a $1 million principal amount. Party E agrees to pay a fixed rate of

12% to Party F. In return, Party F agrees to pay a floating rate of LIBOR + 3% to Party E. Determine an annual net cash flow available for the mortgage company.

6.The current spot rate for the Polish zloty is 2.5 zlotys per dollar or $0.40 per zloty. Party G has access to zlotys at a rate of 7%, while Party H must pay 8 %

to borrow zlotys. On the other hand, Party H can borrow dollars at 9%, while Party G must pay 10% for its dollar borrowings. Party G wishes to obtain $10

million in exchange for 25 million zlotys, while Party H wants to obtain 25 million zlotys in exchange for $10 million. How can these two parties

achieve a lower borrowing rate?