Description of this paper

You have $400,000 in floating rate debt on which you make payments once per year.

Description

solution


Question

1. You have $400,000 in floating rate debt on which you make payments once per year. You would like to convert to a fixed rate. You and a swap counterparty agree to the reference interest rate 6%, with payments to be exchanged once per year.;a. At the end of the first year, the actual interest rate is 4%. Who pays whom, and how much?;b. At the end of the second year, the actual interest rate is 10%. Who pays whom, and how much?;c. Considering that when you first enter the swap, you will not know whether you will be paying or receiving money each year, nor how much the amount will be, why is the swap considered to be a way of hedging risk, instead of being an added risk?;2. Company A can borrow from outside investors at a fixed rate of 4% or a floating rate of LIBOR + 1%.;Company B can borrow from outside investors at a fixed rate of 8% or a floating rate of LIBOR + 3%.;Company A needs a floating rate loan while Company B needs a fixed rate loan. Without working together, this means that A would be borrowing at LIBOR + 1% while B would be borrowing at 8%. Suppose instead that Company A takes the fixed rate loan, Company B takes the floating rate loan, and the companies agree to a swap in which A pays B LIBOR +2%, while B pays A 6% in return.;a. Company A now has three sets of interest rate cash flows. Identify them. Then state the net effect of the cash flows and show that Company A is better off than if it had borrowed at LIBOR + 1%.;b. Company B now has three sets of interest rate cash flows. Identify them. Then state the net effect of the cash flows and show that Company B is better off than if it had borrowed at 8%.;3. A U.S. firm issued a 7% euro-denominated bond priced at ?1000 that now has three years left to maturity. It is also in a currency swap in which it receives 7% per year in euros and pays 5% per year in dollars once per year on principal amounts of ?1000 and $1300.;a. What is the purpose of this swap?;b. Fill in the blanks with cash amounts, being sure to indicate if the amount is in euros or dollars. Each year, this firm pays _____ on the bond, receives _____ on the swap, pays ____ on the swap, and has a total net payment of _____.;4. You believe that Junky Motors bonds may default. You have bought a credit default swap with notional principal $10 million and a CDS spread of 110 basis points.;a. How much do you pay per year as a premium?;b. Suppose that Junky Motors defaults during the coverage period, and its bonds are valued at 30 cents on the dollar. How much do you receive from the CDS writer?;5. You own $50,000 worth of the Vanguard Total Stock Market Exchange Traded Fund (an index fund). You would like to temporarily receive LIBOR instead of the return on the index fund, without facing the transaction cost of selling the fund and then buying it back again later. Identify the specific type of swap that you could use, and describe how it would work. As an example, suppose that at the end of one period, the index fund has dropped 4% while the average LIBOR was 3%.

 

Paper#25716 | Written in 18-Jul-2015

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