exercise_topic_08 - imperfect. 2. (Final examination, 2011)...

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UNIVERSITY OF ESSEX DEPARTMENT OF ECONOMICS Session 2011–12 R. E. Bailey EC372 Economics of Bond and Derivatives Markets Exercise 8: Swap Contracts and Swap Markets 1. (Plain vanilla interest rate swap.) Companies A and B both plan to borrow £15m for 7-years. The companies face differing borrowing costs. Company A can borrow for a fixed rate of 9% per annum or a floating rate of LIBOR + 100b.p. per annum. Company B can borrow for a fixed rate of 11% per annum or a floating rate of LIBOR + 120b.p. per annum. (a) Under what conditions would companies A and B find an interest rate swap beneficial? Suppose that the necessary conditions hold and that you are employed by a financial intermediary to arrange interest rate swaps. Propose a swap agreement which would benefit both companies and the intermediary. (b) Explain the relationship between the swap agreement and a sequence of forward con- tracts for the exchange of interest payments. (c) Discuss the view that swap agreements are possible only because capital markets are
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Unformatted text preview: imperfect. 2. (Final examination, 2011) (a) Describe each of the following types of swap contract, and identify its associated risks: (i) plain vanilla interest rate swap, and (ii) credit default swap. (b) Two companies, A and B , borrow at different interest rates in US dollars ($) and Sterling (), as follows: Dollar ($) Sterling () interest rate interest rate Company A 9% 7% Company B 4% 5% Assume that the present rate of exchange is $1.5=1, that company A seeks to bor-row $12 million for 10 years and that company B seeks to borrow 8 million, also for 10 years. Interest rates are quoted as per cent, per annum. (i) Construct and explain a currency swap that would be attractive to both companies and to a nancial intermediary that arranges the swap. (ii) Identify the risks associated with the swap. What actions could A , B and the inter-mediary take to mitigate these risks? *****...
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