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Understanding Interest Rate Swaps

GlobeCross and IndSwift are offered fixed and floating rate financing options. GlobeCross believes rates will fall while IndSwift thinks they will rise. A banker proposes a swap where GlobeCross pays floating received fixed, and IndSwift does the opposite, saving each on financing costs. The document then provides spot interest rate data and asks to calculate swap rates for years 1 to 5, discusses a currency swap value for a party paying sterling, a currency swap value for a bank receiving dollars and paying sterling after a company bankruptcy, and the value and exit payment for an IRS paying fixed and receiving floating after interest rates start falling.

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222 views2 pages

Understanding Interest Rate Swaps

GlobeCross and IndSwift are offered fixed and floating rate financing options. GlobeCross believes rates will fall while IndSwift thinks they will rise. A banker proposes a swap where GlobeCross pays floating received fixed, and IndSwift does the opposite, saving each on financing costs. The document then provides spot interest rate data and asks to calculate swap rates for years 1 to 5, discusses a currency swap value for a party paying sterling, a currency swap value for a bank receiving dollars and paying sterling after a company bankruptcy, and the value and exit payment for an IRS paying fixed and receiving floating after interest rates start falling.

Uploaded by

Sapcult
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd

Session 4: Swaps

(a) Two companies GlobeCross and IndSwift are planning to raise finance and have
been offered the following rates by the bankers:
Fixed Rate Floating Rate
GlobeCross 11.00% MIBOR+30 bps
IndSwift 12.00% MIBOR+70 bps
The CFO of GlobeCross is of the opinion that interest rates have now peaked and
will soon start declining and hence it would be better to raise finance at a floating
rate. IndSwift people however feel that interest rates will continue to rise and
hence wish to borrow at a fixed rate. A banker is willing to work out a swap
arrangement between these two companies for a fee of 5 bps from each party.
What kind of swap can be arranged between the two companies? What will be the
saving in financing cost to each company?
(b) The term structure of spot interest rates is given below. Find out the swap rate for
a generic fixed-floating interest rate swap with a maturity of five years. Assume
annual payments under the swap.
Maturity Spot
rates
1 7.0000%
2 7.2591%
3 7.5256%
4 7.8008%
5 8.0861%

(c) Work out the swap rates for years 1 to 5 on the basis of data given in the earlier
problem.

(d) A currency swap has a remaining life of 15 months and involves exchanging interest
at 10% on GBP 20 million for interest at 6% on USD 30 million once a year. Assume
a flat term structure in both countries. If swap were negotiated today the interest rates
exchanged would be 4% in dollars and 7% in sterling. Assume annual compounding.
Current exchange rate is 1.85 USD per GBP. What is the value of the swap to the
party paying sterling?

(e) A British bank has entered into a five-year currency swap with an American
corporation under which the bank exchanged 5 million pound sterling for 8 million
US dollars. The bank pays interest at 0.60% p.a. in US dollars and receives interest at
1% p.a. on the sterling. Payments are exchanged at the end of each year. At the end of
the second year the American company declares bankruptcy when the spot exchange
rate is USD 1.58/GBP. Assuming that at the end of the second year the spot interest
rates in the US and UK are 2% and 3% p.a. for all maturities and the interest rate
parity holds, what is the value of the swap for the British bank? All interest rates are
quoted with annual compounding.
(f) Shaman Auto Ltd entered into a 5-year IRS where it pays fixed 10.75% on a notional
of Rs.10 crore and receives MIBOR. Assume annual payments. One year has elapsed
since the swap was entered into and the RBI has recently started cutting interest rates.
Floating rate for the current year is 9%. The management is concerned that since it
pays fixed and receives floating on the swap it will make losses on the swap in a
falling interest rate scenario. As the trader handling the swap book you are asked to
find the value of the swap for the company and the amount to be paid by the company
for exiting the swap arrangement. The term structure of interest rates today is as given
below.

TTM Spot rates

1 year 9.00%

2 year 9.25%

3 year 9.75%

4 year 10.25%

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