Question

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

(b) 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) Swap is one the derivative instruments and is used by investor to reduce the exposure to their position. Interest rate swap is a type of derivative swap where the interest payment is exchanged periodically. Here the interest rate swap is useful because the investor can swap it for fixed rate to variable or variable rates to fixed rate or Fixed rate for fixed rate in other currency or variable rate to variable rate in other currency. Interest rate swap is better when the investor only wants to exchange the periodic payment and not the principal as well and the cost of interest swap is less than the cost of another instrument. Interest rate swap helps the companies in hedging their interest payment obligation.

b) Put option is the option that gives the holder the right to buy but no obligation. The strike price or the exercise price in the put option is the price at which the buyer of put will exercise the put option if the stock price fell below the exercise price. The premium is paid on the purchase of the put option.

Here in the above case the exercise price is $20, so if the stock price fell below $20 then the option will be exercised and the AT Corporation will receive the $20 price per share. The option premium that the AT corporation is paying is $0.85 per put option so that is the cost of put option.