7 Interest Rate Risk

# 1 technically t bond futures permit the short position

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Unformatted text preview: nth LIBOR values). • Fixed CF = (0.02757/2) × \$10 million = \$137,850 (paid to X). • First floating CF = (0.029694/2) × \$10 million = \$148,470 (paid to L). Ec 174 INTEREST RATE RISK p. 14 of 17 3.0% X rx = 2.757% F rℓ + 0.1% Fig. 3a Libor rx = 2.757% Fig. 3b X F rℓ – 0.2% Libor 2.5% 3) Scenario #1 – Using swaps to transform a liability. [Fig 3a] • F has borrowed money and pays Libor + 0.1% to the lenders. • After the swap, F pays Libor + 0.1% + 2.757% – Libor. • F now has a fixed payment liability of 2.857%. • X pays 3.0% fixed rate on a large mortgage. • After the swap, X pays 3.0 % + Libor – 2.757%. • X now has a variable payment liability of Libor + 0.243%. 4) Scenario #2 – Using swaps to transform an asset. [Fig. 3b] • F earns fixed income at 2.5% on a bond portfolio. • After the swap, F receives 2.5% + Libor – 2.757%. • F now has a variable income stream of Libor – 0.257%. • X earns a variable income stream of Libor – 0.2% on a money market portfolio. • After the swap, X receives Libor – 0.2% + 2.757% – Libor. • X now has a fixed income stream of 2.557%. d) In fact, most swaps are done thru OTC dealers who specialize in this market. [Fig. 4] Ask rℓ Bid X Dealer F 7% rx = 7.05% rx = 6.95% Fig. 4 rℓ rℓ 1) X corp had fixed 7% payments and converts to variable payments of rℓ + 0.05% 2) F had variable payments at Libor and converts to fixed payments at 7.05%. 3) The dealer bids 6.95% fixed rate to receive Libor, and asks 7.05% to pay Libor. It will make π = (0.0705 – 0.0695)A, or 0.1% of notional principal. 4) Swap rate = average of bid and asked fixed rates; rx = 7% above. 5) The dealer bears default risk; if either X or F reneges on swap agreement, the dealer must still meet its obligation to the other. They use FRAs and interest rate futures to hedge this risk. Ec 174 INTEREST RATE RISK p. 15 of 17 APPENDIX - - BOND FORMULAS YIELD TO MATURITY Settlement date November 28, 2008 =date(yyyy,mm,dd) Maturity date November 15, 2018 =date(yyyy,mm,dd) Annual coupon rate 3.750% (decimal) Bond price (clean/flat/quoted) 106.7800 (% of M) Redemption value 100 (% of M) Coupon payments/year 2 YTM = 2.959% =yield(b4,b5,…,b9) BOND INVOICE PRICES Settlement date January 1, 2000 =date(yyyy,mm,dd) Maturity date September 11, 2015 =date(yyyy,mm,dd) Annual coupon rate 6.000% (decimal) YTM 4.000% (decimal) Redemption value 100 (% of M) Coupon payments/year 2 Basis (b) 1 Clean (flat/quoted) Price (% of M) = 123.1382 =price(b13,b14,b15,b16,b17,b18) Days since last coupon = 112 =coupdaybs(b13,b14,b18,b19) Days in coupon period = 182 =coupdays(b13,b14,b18,b19) Accrued Interest (% of M) = 1.846153846 =(b21/b22)*(b15/2)*100 Invoice (dirty) Price (% of M) = 124.9844 =b20+b23 b = basis: M = \$ 1,000.00 0 = US 30/360 (Co...
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