Question 3.

(This question has two parts: I and II)

Part I. As a pension fund manager, you anticipate that you have to pay out 8 percent on $100 million for the next eight years. The payment is made semi-annually. You currently hold $100 million of floating-rate note that pays LIBOR + 2.5 percent. What is your potential risk? To eliminate or reduce your risk, you arrange a swap with a dealer who agree to pay you 6 percent fixed, while you pay him LIBOR. The swap payment is made semi-annually as well. Determine your cash flow as a percent of notional amount at each payment date under this arrangement and assess if you have sufficient cash flow to pension fund holder. (6 Marks)

Part II. A hedge fund is currently engaged in a plain vanilla interest rate swap with a company named NeverDown. Under the terms of the swap, the hedge fund receives six-month LIBOR and pay 8 percent per annum on a principle of $100 million for five years. Payments are made every 6 months. Assume that the interest rates start to soar after two years and NeverDown defaults on the sixth payment date when the LIBOR rate is 10 percent for all maturities (with semi-annual compounding). The 6-months LIBOR rate 6-months ago is 9.5 percent. What is the loss to the hedge fund? (6 Marks)

(Total 6 Marks + 6 Marks = 12 Marks)