XSIF Investment Trust has bonds worth $20 million in par value maturing in one year. To maintain the duration and quality ratings of its overall bond fund, the trust plans to reinvest the principal in three-year, option-free bonds with a quality rating of A. Such bonds are currently trading 200 basis points above comparable three-year Treasury notes. XSIF Trust also could invest in threeyear, A-rated, floating-rate bonds. Such bonds are presently trading at 150 basis points above the LIBOR. Currently, three-year T-notes are trading to yield 6%.

XSIF is worried, though, that the Fed will lower interest rate in the next year to stimulate a sluggish economy. As a result, the trust would like to lock in a rate on its $20 million investment. The Trust is considering locking in a rate by entering a forward swap agreement with Fort Washington Bank. To hedge its future loan, Fort Washington is willing to provide XSIF a one-year forward swap agreement on a three-year 6.5%/LIBOR swap.

a. Explain the forward swap position that XSIF would need to take in order to lock in the rate on a three-year, fixed-rate bond investment to be made in one year.

b. Given XSIF’s swap position, explain how it would obtain a fixed rate for three years at the forward swap’s expiration date by investing in A-rated floating-rate notes at LIBOR plus 150 bp. What is the fixed rate XSIF would earn from this hedged investment?