Ten-year "plain vanilla" swaps are 3% against 6-month LIBOR. 1 A bank has a 10-year loan to a customer which pays 6-month LIBOR + 2%. 1. What is the bank's risk? 2. How should the bank use the IRS to hedge / transform the risk? 3. Draw the diagram to show the cash flow dynamics of the swap and the loan. 4. The swaps dealer, who is the counterparty to this swap, is also the counterparty to the investor in the lecture swap example. What is the dealer's risk? How should the dealer be compensated for the risk? A company has issued a ten-year bond with a coupon of 5.5%. 1. How can it use the above swap to transform its exposure to a floating rate? 2. Why might it want to do so? A hedge fund expects ten-year interest rates to rise soon. 1. How would it set up a trade in the cash market that reflects this view? What does the fund do after its expectations have been realized? 2. How would it use the swap as an alternative? What would it do after its expectations are realized