{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

021 - 21 Swaps Economic Analysis and Pricing Answers to...

Info icon This preview shows pages 1–4. Sign up to view the full content.

View Full Document Right Arrow Icon
214 Answers to Questions and Problems 1. A trader buys a bond that pays an annual coupon based on LIBOR with a principal amount of $10 million. The actual payment in each year depends on the level of LIBOR observed one year previously. The same trader simultaneously sells a $10 million dollar bond that pays a fixed rate of 7 percent interest and also has an annual coupon. Both bonds have a maturity of five years and are priced at par. The trader also enters a pay-fixed interest rate swap with annual payments, a tenor of five years, and a notional principal of $10 mil- lion. For the swap, the fixed rate is 7 percent and the floating rate is LIBOR. The swap also pays in arrears. A. Construct a time line for each bond showing the payments associated with the bond. FRN Time Line: Coupon Bond Time Line: 0 1 2 3 4 5 Year $10,000,000 $700,000 $700,000 $700,000 $700,000 $700,000 + $10,000,000 0 1 2 3 4 5 Year 0 LIBOR × $10,000,000 1 LIBOR × $10,000,000 2 LIBOR × $10,000,000 3 LIBOR × $10,000,000 4 LIBOR × $10,000,000 $10,000,000 + –$10,000,000 21 Swaps: Economic Analysis and Pricing
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
ANSWERS TO QUESTIONS AND PROBLEMS 215 B. Construct a time line showing the net payments resulting from the two bonds. Bond Portfolio Time Line: C. Construct a time line showing the payments for the swap. Pay-Fixed Swap Time Line: D. Based on the two time lines from parts B and C, what conclusion can you draw regarding the relationship between swaps and bond portfolios? A plain vanilla swap can be constructed or synthesized by a bond portfolio. This is the case, because the bond portfolio and the swap have identical cash flows. This suggests that the prices of bonds can be used to value swaps, and that swaps can be used to transform cash flow patterns on bond portfolios. 2. Assume that today is December 17, 2003. A firm enters a plain vanilla interest rate swap as the receive-fixed party on a swap with a tenor of one year, quarterly payments at the end of the next four quarters, and a notional principal of $25 million. At the same time, this firm buys a strip of Eurodollar futures for the next four con- tracts, with 25 contracts per expiration. (Ignore daily settlement; in other words, assume that all futures-related cash flows occur at the expiration of the futures contract, which occurs at the end of each quarter.) At present, t 0, the LIBOR yield curve is flat at 8 percent, and the fixed rate on the swap is also 8 percent. A. Complete the following table using our familiar LIBOR t notation. Assume that the Eurodollar futures rate converges to LIBOR at expiration. 0 1 2 3 4 5 Year 0 LIBOR × $10,000,000 1 LIBOR × $10,000,000 2 LIBOR × $10,000,000 3 LIBOR × $10,000,000 4 LIBOR × $10,000,000 $700,000 $700,000 $700,000 $700,000 $700,000 0 1 2 3 4 5 Year 0 LIBOR × $10,000,000 1 LIBOR × $10,000,000 2 LIBOR × $10,000,000 3 LIBOR × $10,000,000 4 LIBOR × $10,000,000 $700,000 $700,000 $700,000 $700,000 $700,000 QuarterNet Receive-Fixed Swap Cash Flow Net Long Futures Cash Flow 0 0 0 1 (0.08 LIBOR 0 )/4 $25,000,000 (0.08 LIBOR 1 )/4 $25,000,000 2 (0.08 LIBOR 1 )/4 $25,000,000 (0.08 LIBOR 2 )/4 $25,000,000 3 (0.08 LIBOR 2 )/4 $25,000,000 (0.08 LIBOR 3 )/4 $25,000,000 4 (0.08 LIBOR 3 )/4 $25,000,000 (0.08 LIBOR 4 )/4 $25,000,000
Image of page 2
216 CHAPTER 21 SWAPS : ECONOMIC ANALYSIS AND PRICING All of the futures contracts should be entered at 8 percent, because the yield curve is flat. The payoff on each futures depends on the deviation of spot LIBOR at expiration from the initial futures rate of 8 percent. With
Image of page 3

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 4
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern