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Companies X and Y have been offered the following interest rates per annum on a $10 million 2-year loan: Fixed Rate Floating Rate Company X 5.0%...
Companies X and Y have been offered the following interest rates per annum on a $10 million 2-year loan:
Fixed Rate Floating Rate Company X 5.0% LIBOR-0.1% Company Y 6.4% LIBOR+0.1%
Company X requires a floating-rate loan; company Y requires a fixed-rate loan. All interest rates in the table are reported with semi-annual compounding. The fixed and floating payments are exchanged every six months.
a) Explain the contractual agreement between the parties in a "plain vanilla" interest rate swap. Assume that a swap is arranged in which a financial institution acts as an intermediary between the two companies. Design a currency swap that is equally beneficial for the two companies assuming that the financial institution earns 40 basis points per annum. Show your calculations and use a diagram to explain how the swap is arranged.
b) Suppose that the swap has been in existence for some time and at the present moment the swap has a remaining life of 9 months. The six-month LIBOR rate three months ago was 4% per annum (with semi-annual compounding). The average of the bid-offer rate being exchanged for six-month LIBOR in swaps of all maturities is currently 2% per annum reported with continuous compounding. Calculate the current value of the swap for company X.
c) Discuss the risks for the parties in an interest rate swap. Suppose now that the swap has a remaining life of 6 months and company Y declares bankruptcy and defaults on its current and future swap payments. Calculate the losses that arise as a result of the default and explain which party bears these losses. Use the same rates in your calculations as in Part (b).
