Tutorial questions – Interest rate swap
• You work at the swap trading desk of an investment bank and two of your clients are offered the following annual rates for an investment of £10 million for 5 years:
Fixed rate
Floating rate
Client A
4.6%
Libor +0.2%
Client B
4.0%
Libor – 0.1%
Client A requires a floating-rate investment and client B requires a fixed-rate investment. To benefit from the differences between rates and make the transaction equally attractive to both clients, you propose the following transactions to the clients, each of them with the same notional amount of £10 million:
• Client A should invest the money at the fixed rate of 4.6% for 5 years
• Client B should invest the money at Libor – 0.1% for 5 years
• Client A should enter a 5-year swap with the bank in which the client receives Libor annually and pay the fixed swap rate of 4.3%
• Client B should enter a 5-year swap with the bank in which the client would pay Libor annually and receive the fixed rate of 4.2%
• Draw the cash flows between the clients and the bank as a result of the transactions above
• What is the rate of return obtained by each client on their investments? And what is the compensation earned by the bank for the intermediation of the swaps?
• Discuss the exposure of each counterparty to market risk, credit and counterparty risk when entering the transactions mentioned above.
• A company enters into an interest rate swap where it is receiving fixed and paying LIBOR. When interest rates increase, which of the following is true?
• The value of the swap to the company increases
• The value of the swap to the company decreases
• The value of the swap can either increase or decrease
• The value of the swap does not change providing the swap rate remains the same
• A company can invest funds for five years at LIBOR minus 10 basis points. The five-year swap rate is 2%. What fixed rate of interest can the company earn by using the swap?
• Depends on the Libor rate
• 1.9%
• 2.0%
• 2.1%
TRUE OR FALSE ?
• Buying a receiver interest rate swap provides protection to a borrower that pays periodically the Libor rate plus a spread.
• One advantage of swap contracts is that the principal or notional amount is not exchanged at initiation; hence the credit risk is low.
• A receiver I.R. swap can be decomposed into a long FRN and a short coupon bond.
• A swap seller in an I.R. swap transaction is also a fixed rate receiver.
• In an I.R. swap transaction, the bank is not exposed to counterparty risk.