Question

1. Explain why would a company engage in an interest rate swap over other means of managing risk?

2. The AT Corporation is holding a large number of XXY Bank shares in an investment portfolio and wishes to protect the value of the investment. The XXY Bank shares currently trade at $22.00. The AT Corporation buys a put option with an exercise price of $20.00 per share and a premium of $0.85 per share. By entering this option strategy, explain whether the AT Corporation will exercise the option if the spot price is above or below the exercise price. [You are required to clearly define a put option, spot price, exercise price, and premium - in order to explain your final answer].

Answer 1

a) Let us discuss the importance of interest rate swaps. In an interest rate swap, the total agrees to exchange the payments that are related to two different underlying indexes. Since this is a derivate transaction there is only notional principal . Let me better explain how parties benefit by swap arrangement with the help of the below example.Financial institutes and bank use interest rate swap to change the interest they pay on an outstanding debt and also sometimes it also change the maturity of the debt.

Interest rate swaps are widely used to manage the risks since they benefit both the parties in the sawp transaction.

Let me give an example of swap transaction.

Firm	Fixed	Floating	Preference
ABC	10.00%	Libor +3%	Floating
XYZ	12.00%	Libor + 2%	Fixed

Here we can clearly see that ABC has benefit of fixed rate and XYZ has benefit of floating rate but their preferences are entirely different. Hence they will enter into a swap where XYZ will take floating and ABC will take Fixed .

At the end of the day effective cost for both the firms will be 10+ Libor + 2%

IF they didnot enter swap the effective rate will be 12+Libor +3%

Hence the benefit will be (12+libor+3%) - (10+libor+2%) = 3%

Now this 3% cost saving can be shared between both the firms

Similarly banks also sell swaps with fixed and floating quotations

b) First of all a put option is Right to sell. Here AT corporation has brought the put option that means it anticipation to sell the stock at a particular price and is afraid of stock price falling as the stock price falls . Hence inorder to benefit from the stock price falling it has brought the put option.

As per the Given data the spot price = 22

And the exercise price is 20

Option premium =0.85

Now when the share price raises the option lapsed when the share price goes below we will get loss by holding the share and profit by holding the profit on put option

Let us assume that the share price falls to $15

Now loss on holding share is 22-15 = 7

Profit on the option will be - We have right to sell at 20 the share price is 15 hence we will exercise the right accordingly profit is 20-15 = 5

Net pay off after considering option premium will be 5-0.85 = 4.15

Hence we reduced the loss by holding the put option.