7. The a sponsor of a defined benefit plan, the Jackson Corporation, and the Alp

Question

7. The a sponsor of a defined benefit plan, the Jackson Corporation, and the Alpha- Reliable Asset Management Corporation (an asset management firm) enter into a three-year swap with a notional amount of $250 million with the following terms: every year for the next three years, the Jackson Company agrees to pay Alpha-Reliable Asset Management the return realized on the S&P 500 stock index for the year minus 300 basis points and receive from Alpha-Reliable Asset Management 7%. a. What type of swap is it? b. In the first year payments are to be exchanged, suppose that the return on the S&P 500 index is 6%,What is the amount of the payment that the two parties must make to each other?

Explanation / Answer

7

a. Since we are paying in equity or index terms and receiving in fixed terms, this means its an Equity swap, wherein we pay based on index return (here S&P 500 less 3%) and receive fixed return of 7%. Please note the cashflows are netted simliar ti interest swaps,

b. Cashflow to party paying index return and receiving fixed = (Notional value) * ((Fixed rate)*(360/no. of days) - (return on index))

= 250,000 * (7%*(360/360) - (6% - 3%))

=250,000 * ((7%*1 )- 3%)

=250,000 * (7%-3%)

=250,000 * 4%

Net Cash flow received by partypaying index return at end of first year = $10,000

Please note, only net payments are exchanged and not individual cashflows by each party

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