Question

A commercial bank purchased a $100M par, 10-year bond with 4% (semi-annual) coupons, and wants to convert this asset to be LIBOR based. A 10-year interest rate swap is available with fixed rates of 3.48% (bid) and 3.52% (offer), where all rates are semi-annual. i] Specify the swap trade. ii] What variable rate does the bank earn?

Answer 1

i) The specified swap trade is ''Interest rate swap'', which is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swap usually involve the exchange of fixed interest rate for floating interest rate or vice versa, to reduce or increase exposures to fluctuations in interest rate.

In the given case bank has purchased a asset with fixed interest receivable i.e 4% semi annually and now it want to covert the asset to Libor(variable interest) based for which deal is available i.e to receive variable(LIBOR) against fixed payment @ 3.84%/3.52% to agent.

ii) Swap will be as follows,

Bank will receive 4% semi annual on the bond and will pay 3.52% semi annual to agent(offer rate) and will receive the prevailing LIBOR rate against it.

Outflow = 3.52%(offered by agent for variable payment to bank) on $100M

Inflow = (4% on original bond + LIBOR from agent) on 100M.

Net Inflow = Outflow - Inflow

Net Inflow = 4%+LIBOR-3.52% = (0.48%+LIBOR) ON 100M will be earnig for bank over 10 years.