Question

a) A finance minister from the G7 group of nations said: A swap has more default risk than a corresponding bank loan based on the same notional principal and that is why the subprime crisis occurred due to the implosion of credit default swaps. Critically evaluate his statement.

b) What is the value of a swap with the following terms: A financial institution has agreed to pay 7% per annum and receive 3-month LIBOR in return on a notional principal of $180 million with payments being exchanged every 3 months. The swap has a remaining life of 14 months. The average of the bid and offer fixed rates currently being swapped for 3-month LIBOR is 10.5% per annum for all maturities with continuous compounding. The current bank fixed deposit rate is 13%. The three-month LIBOR rate 1 month ago was 8.5% per annum.