SUGGESTED ANSWERS

CHAPTER 7: SWAPS

Practice Questions

1. Problem 7.8.
Explain why a bank is subject to credit risk when it enters into two offsetting swap
contracts.

At the start of the swap, both contracts have a value of approximately zero. As time
passes, it is likely that the swap values will change, so that one swap has a positive
value to the bank and the other has a negative value to the bank. If the counterparty on
the other side of the positive-value swap defaults, the bank still has to honor its
contract with the other counterparty. It is liable to lose an amount equal to the positive
value of the swap.

2. Problem 7.9.
Companies X and Y have been offered the following rates per annum on a $5 million
10-year investment:

Fixed Rate Floating Rate

Company X 8.0% LIBOR
Company Y 8.8% LIBOR

Company X requires a fixed-rate investment; company Y requires a floating-rate

investment. Design a swap that will net a bank, acting as intermediary, 0.2% per
annum and will appear equally attractive to X and Y.

The spread between the interest rates offered to X and Y is 0.8% per annum on fixed
rate investments and 0.0% per annum on floating rate investments. This means that
the total apparent benefit to all parties from the swap is 08%perannum Of this 0.2%
per annum will go to the bank. This leaves 0.3% per annum for each of X and Y. In
other words, company X should be able to get a fixed-rate return of 8.3% per annum
while company Y should be able to get a floating-rate return LIBOR + 0.3% per
annum. The required swap is shown in Figure S7.1. The bank earns 0.2%, company X
earns 8.3%, and company Y earns LIBOR + 0.3%.

Figure S7.1 Swap for Problem 7.9

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 3. Problem 7.10.
A financial institution has entered into an interest rate swap with company X. Under
the terms of the swap, it receives 10% per annum and pays six-month LIBOR on a
principal of $10 million for five years. Payments are made every six months. Suppose
that company X defaults on the sixth payment date (end of year 3) when the interest
rate (with semiannual compounding) is 8% per annum for all maturities. What is the
loss to the financial institution? Assume that six-month LIBOR was 9% per annum
halfway through year 3.

At the end of year 3 the financial institution was due to receive $500,000 (  05 10 %
of $10 million) and pay $450,000 (  05  9 % of $10 million). The immediate loss is
therefore $50,000. To value the remaining swap we assume than forward rates are
realized. All forward rates are 8% per annum. The remaining cash flows are therefore
valued on the assumption that the floating payment is
05  008 10 000 000  $400 000 and the net payment that would be received is
500 000  400 000  $100 000 . The total cost of default is therefore the cost of
foregoing the following cash flows:

3 year: $50,000
3.5 year: $100,000
4 year: $100,000
4.5 year: $100,000
5 year: $100,000

Discounting these cash flows to year 3 at 4% per six months we obtain the cost of the
default as $413,000.

4. Problem 7.12.
Companies A and B face the following interest rates (adjusted for the differential
impact of taxes):

A B
US Dollars (floating rate) LIBOR+0.5% LIBOR+1.0%
Canadian dollars (fixed 5.0% 6.5%
rate)

Assume that A wants to borrow U.S. dollars at a floating rate of interest and B wants
to borrow Canadian dollars at a fixed rate of interest. A financial institution is
planning to arrange a swap and requires a 50-basis-point spread. If the swap is
equally attractive to A and B, what rates of interest will A and B end up paying?

Company A has a comparative advantage in the Canadian dollar fixed-rate market.

Company B has a comparative advantage in the U.S. dollar floating-rate market. (This
may be because of their tax positions.) However, company A wants to borrow in the
U.S. dollar floating-rate market and company B wants to borrow in the Canadian

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dollar fixed-rate market. This gives rise to the swap opportunity.
The differential between the U.S. dollar floating rates is 0.5% per annum, and the
differential between the Canadian dollar fixed rates is 1.5% per annum. The difference
between the differentials is 1% per annum. The total potential gain to all parties from
the swap is therefore 1% per annum, or 100 basis points. If the financial intermediary
requires 50 basis points, each of A and B can be made 25 basis points better off. Thus
a swap can be designed so that it provides A with U.S. dollars at LIBOR  0.25% per
annum, and B with Canadian dollars at 6.25% per annum. The swap is shown in
Figure S7.2.

Figure S7.2 Swap for Problem 7.12

Principal payments flow in the opposite direction to the arrows at the start of the life
of the swap and in the same direction as the arrows at the end of the life of the swap.
The financial institution would be exposed to some foreign exchange risk which could
be hedged using forward contracts.

5. Problem 7.15.
Why is the expected loss from a default on a swap less than the expected loss from the
default on a loan with the same principal?

In an interest-rate swap a financial institution’s exposure depends on the difference

between a fixed-rate of interest and a floating-rate of interest. It has no exposure to the
notional principal. In a loan the whole principal can be lost.

6. Problem 7.16.
A bank finds that its assets are not matched with its liabilities. It is taking floating-rate
deposits and making fixed-rate loans. How can swaps be used to offset the risk?

The bank is paying a floating-rate on the deposits and receiving a fixed-rate on the
loans. It can offset its risk by entering into interest rate swaps (with other financial
institutions or corporations) in which it contracts to pay fixed and receive floating.

7. Problem 7.18.
The LIBOR zero curve is flat at 5% (continuously compounded) out to 1.5 years. Swap
rates for 2- and 3-year semiannual pay swaps are 5.4% and 5.6%, respectively.
Estimate the LIBOR zero rates for maturities of 2.0, 2.5, and 3.0 years. (Assume that
the 2.5-year swap rate is the average of the 2- and 3-year swap rates.)

The two-year swap rate is 5.4%. This means that a two-year LIBOR bond paying a

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semiannual coupon at the rate of 5.4% per annum sells for par. If R2 is the two-year
LIBOR zero rate
27e00505  27e00510  27e00515  1027e R2 20  100
Solving this gives R2  005342 . The 2.5-year swap rate is assumed to be 5.5%. This
means that a 2.5-year LIBOR bond paying a semiannual coupon at the rate of 5.5%
per annum sells for par. If R25 is the 2.5-year LIBOR zero rate
275e00505  275e00510  275e00515  275e00534220  10275e R25 25  100
Solving this gives R25  005442 . The 3-year swap rate is 5.6%. This means that a 3-
year LIBOR bond paying a semiannual coupon at the rate of 5.6% per annum sells for
par. If R3 is the three-year LIBOR zero rate
28e00505  28e00510  28e00515  28e00534220  28e00544225

1028e R3 30  100

Solving this gives R3  005544 . The zero rates for maturities 2.0, 2.5, and 3.0 years
are therefore 5.342%, 5.442%, and 5.544%, respectively.

Further Questions

8. Problem 7.21.
The one-year LIBOR rate is 10% with annual compounding. A bank trades swaps
where a fixed rate of interest is exchanged for 12-month LIBOR with payments being
exchanged annually. Two- and three-year swap rates (expressed with annual
compounding) are 11% and 12% per annum. Estimate the two- and three-year LIBOR
zero rates.

The two-year swap rate implies that a two-year LIBOR bond with a coupon of 11%
sells for par. If R2 is the two-year zero rate
11/1.10  111/ (1  R) 2  100
so that R2  01105 The three-year swap rate implies that a three-year LIBOR bond
with a coupon of 12% sells for par. If R3 is the three-year zero rate
12 /1.10  12 /1.11052  112 / (1  R3 )3  100
so that R3  01217 The two- and three-year rates are therefore 11.05% and 12.17%
with annual compounding.

9. Problem 7.24.
For all maturities the US dollar (USD) interest rate is 7% per annum and the
Australian dollar (AUD) rate is 9% per annum. The current value of the AUD is 0.62
USD. In a swap agreement, a financial institution pays 8% per annum in AUD and
receives 4% per annum in USD. The principals in the two currencies are $12 million
USD and 20 million AUD. Payments are exchanged every year, with one exchange
having just taken place. The swap will last two more years. What is the value of the
swap to the financial institution? Assume all interest rates are continuously
compounded.

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The financial institution is long a dollar bond and short a USD bond. The value of the
dollar bond (in millions of dollars) is
048e0071  1248e0072  11297
The value of the AUD bond (in millions of AUD) is
16e0091  216e0092  19504
The value of the swap (in millions of dollars) is therefore
11297 19504  062  0795
or –$795,000.
As an alternative we can value the swap as a series of forward foreign exchange
contracts. The one-year forward exchange rate is 062e002  06077 . The two-year
forward exchange rate is 062e0022  05957 . The value of the swap in millions of
dollars is therefore
(048  16  06077)e0071  (1248  216  05957)e0072  0795
which is in agreement with the first calculation.

10. Problem 7.25.

Company X is based in the United Kingdom and would like to borrow $50 million at a
fixed rate of interest for five years in U.S. funds. Because the company is not well
known in the United States, this has proved to be impossible. However, the company
has been quoted 12% per annum on fixed-rate five-year sterling funds. Company Y is
based in the United States and would like to borrow the equivalent of $50 million in
sterling funds for five years at a fixed rate of interest. It has been unable to get a quote
but has been offered U.S. dollar funds at 10.5% per annum. Five-year government
bonds currently yield 9.5% per annum in the United States and 10.5% in the United
Kingdom. Suggest an appropriate currency swap that will net the financial
intermediary 0.5% per annum.

There is a 1% differential between the yield on sterling and dollar 5-year bonds. The
financial intermediary could use this differential when designing a swap. For example,
it could (a) allow company X to borrow dollars at 1% per annum less than the rate
offered on sterling funds, that is, at 11% per annum and (b) allow company Y to
borrow sterling at 1% per annum more than the rate offered on dollar funds, that is, at
11 12 % per annum. However, as shown in Figure S7.4, the financial intermediary
would not then earn a positive spread.

Figure S7.4 First attempt at designing swap for Problem 7.25

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To make 0.5% per annum, the financial intermediary could add 0.25% per annum, to
the rates paid by each of X and Y. This means that X pays 11.25% per annum, for
dollars and Y pays 11.75% per annum, for sterling and leads to the swap shown in
Figure S7.5. The financial intermediary would be exposed to some foreign exchange
risk in this swap. This could be hedged using forward contracts.

Figure S7.5 Final swap for Problem 7.25