Question

(a) Your company has a five year floating rate bank loan at current rates. If the expected floating rates are 1% for the first three years and then 2% for year 4 and 3% for year 5, what is a fair fixed rate in an interest rate swap? Do your calculation based on the present value of the expected payments using continuous compounding and semi-annual payments.

(b) Do you have high or low counterparty risk in this swap? Explain

Answer 1

(a)

FIXED RATE SWAP = 1.66%

in a fair swap

average floating rate =fixed rate

average floating rate

suppose value of loan is 100 with semi annual compunding-

year	amount	rate	value of amunt
1	100	1.005	100.5
	100.5	1.005	101.0025
2	101.0025	1.005	101.5075125
	101.5075125	1.005	102.0150501
3	102.0150501	1.005	102.5251253
	102.5251253	1.005	103.0377509
4	103.0377509	1.01	104.0681284
	104.0681284	1.01	105.1088097
5	105.1088097	1.015	106.6854419
	106.6854419	1.015	108.2857235

value of loan at the end of 5 years with interst = 108.285

average interest = (108.29 / 100) - 1 = 8.285%

So the fair fixed rate shoulf be = 8.285%/5 = 1.66%

so lets see the value of fixed rate swap = 100 + (100 x 1.66% x 5) = 108.285

Hence fixed rate swap should be 1.66%

(b)

The main risk associated with swaps is counterparty risk. This is the risk that the counterparty to a swap will default and be unable to meet its obligations under the terms of the swap agreement. If the holder of the floating rate is unable to make payments under the swap agreement, the holder of the fixed-rate has credit exposure to changes in the interest rate agreement. This is the risk the holder of the fixed-rate was seeking to avoid.

FIXED SWAP HOLDER HAS COUNTERRISK AFTER 3 YEARS WHEN INTEREST RATE INCREASES TO 2% SINCE THE INTERST RATE OF FLOATING RATE EXCEEDS 1.66% UNDER FIXED RATE THERE ARE CHANCES THAT FLOATING RATE HOLDING MIGHT DEFAULT AFTER 3 YEAR

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