1. Why might a firm want to use an interest rate swap? 2. What is basis risk? Ex
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1. Why might a firm want to use an interest rate swap? 2. What is basis risk? Explain it as it relates to a currency swap 3. The Bank of Tennessee has negotiated a plain vanilla swap in which it will exchange fixed payments of 4 percent for floating payments equal to LIBOR plus 92 percent at the end of each of the next three years. In the first year, LIBOR is 4 percent; in the second year, 4. percent; in the third year, LIBOR is 3 percent. What is the total net payment the Bank of Tennessee makes over the three-year period if the notional principal is $10 million? 5. Lizard National Bank purchases a three-year interest rate cap for a fee of 2 percent of notional principal valued at S50 million, with an interest rate ceiling of 7 percent and LIBOR as the index representing the market interest rate. Assume that LIBOR is expected to be 4 percent, 4.5 percent, and 5 percent at the end of each of the next three years, respectively. The total payments received (or paid) by Lizard, including the initial fee, are S,Explanation / Answer
Q1: In an interest rate swap a company receives amounts based on a floating rate in exchange for a fixed amount of money. This is a form of hedging and hedges the risk of the company to losses arising from interest rate fluctuations.
Q2. Currency swap relates to exchange of interest or principal in one currency for another. Basis risk occurs when you pay one interest index and receive another. It is the risk that the value of the contract may not move as per the value of the underlying asset. In case of a currency swap basis risk will arise due to currency fluctuations.
Q3. Amount paid by Bank of Tenesse= 4%*10 million * 3 years = 1,200,000
Amount received= 10million*(4.2%+4.2%+3.2%) = 1,160,000
Net payment made = 1200,000- 1160,000 = $40,000
Q5. The fee paid = 2%*50 million = $ 1million
Since LIBOR did not exceed the cap, there will be no receipts
Hence net payment = -$1 million
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