Question Three TYG Bank is a small bank which offers a range of banking and credit facilities to both individual and corporate customers. TYG Bank generates most of its funds for lending by taking deposits from customers who are paid a variable rate of interest in line with market conditions. TYG Bank generates revenue from acting as an intermediary for interest rate swaps. In order to give itself maximum flexibility, TYG Bank does not necessarily identify two clients who have matching requirements. Instead, the bank will act as a counter party to any entity who meets its credit criteria. Ideally, the banks portfolio of swaps will tend to balance one another in terms of the mix of fixed and floating positions and the maturity of the arrangements. TYG Bank has been approached by DEF Co, a major quoted company with a sound credit rating. DEF Co has a $50m loan outstanding on which it is paying a variable rate of interest of LIBOR + 0.8% per annum. This loan has four years remaining and DEF Cos directors are concerned that interest rates may rise. DEF Cos directors have asked TYG Bank to arrange a swap that would give DEF Co a fixed rate of interest. TYG Bank has offered DEF Co a swap arrangement whereby TYG Bank will borrow $50m from DEF Co at LIBOR + 0.8% per annum and will lend $50m to DEF Co at a fixed rate of 5.0% per annum. The two parties will pay the net sum due to one another at the end of each of the next

four years. TYG Bank will charge DEF Co an annual commission of 0.2% on the $50m loan at the end of each year. The present LIBOR is 4.1% per annum. The swaps department of TYG Bank is conducting some scenario planning in order to determine TYG Banks exposure arising from this arrangement. The swaps department envisages three likely scenarios: Scenario 1 LIBOR will remain at 4.1% per annum for the duration of the swap Scenario 2 LIBOR will remain at 4.1% per annum for one year and will then fall to 3.9% for the remaining duration of the swap Scenario 3 LIBOR will remain at 4.1% per annum for one year and will then rise to 5.6% for the remaining duration of the swap TYG Bank discounts cash flows from such projects at 7%. Required: (a) Calculate the net present value (NPV) of the cash flows that TYG Bank will generate from this swap under each of the three scenarios identified by the swaps department. [8 marks] (b) Advise TYG Bank on the risks that will arise from this swap arrangement. [6 marks]

(c) Explain how TYG Bank might mitigate the risks arising from this swap and identify the

difficulties in doing so. [6 marks]

(d) Evaluate the benefits to DEF Co of entering into this swap arrangement. [5 marks]

[Total: 25 marks] [Total: 25 marks]