Case Studies: Finance, Foreign Exchange and Interest Rates
CHAPTER 15
1. Vanilla Swaps. Cleveland Insurance Company has just negotiated a three-year plain vanilla swap in which it will exchange fixed payments of 8 percent for floating payments of LIBOR + 1 percent. The notional principal is $50 million. LIBOR is expected to 7 percent, 9 percent, and 10 percent, respectively, at the end of each of the next three years.
a. Determine the net dollar amount to be received (or paid) by Cleveland each year.
ANSWER:
End of Year:
END OF YEAR
1
2
3
LIBOR
7
9
10
Floating Rate Received
8
10
11
Fixed Rate Paid
8
8
8
Swap Differential
0
2
3
Net Dollar Amount Received
(Based on a Notional Value of $50 Million)
0
1000000
1500000
b. Determine the dollar amount to be received (or paid) by the counterparty on this interest rate swap each year based on the forecasts of LIBOR assumed above.
ANSWER: Year 1 = $0; Year 2 = $1,000,000 paid; Year 3 = $1,500,000 paid
2. Interest Rate Caps. Northbrook Bank purchases a four-year cap for a fee of 3 percent of notional principal valued at $100 million, with an interest rate ceiling of 9 percent, and LIBOR as the index representing the market interest rate. Assume that LIBOR is expected to be 8 percent, 10 percent, 12 percent, and 13 percent, respectively, at the end of each of the next four years.
a. Determine the initial fee paid, and also determine the expected payments to be received by
Northbrook if LIBOR moves as forecasted.
ANSWER:
End of Year:
0
1
2
3
4
LIBOR
8
10
12
13
Interest Rate Ceiling
9
9
9
9
LIBOR’s Percentage
Points Above the
Ceiling
0
1
3
4
Payments to be
Received (Based on
$100 Million of
Notional Principal
0
1000000
3000000
4000000
Fee Paid
3000000
b. Determine the dollar amount to be received (or paid) by the seller of the interest rate cap based on the forecasts of LIBOR assumed above.
ANSWER:
End of
Year 0 = $3,000,000 received
Year 1 = $0
Year 2 = $1,000,000
1. Vanilla Swaps. Cleveland Insurance Company has just negotiated a three-year plain vanilla swap in which it will exchange fixed payments of 8 percent for floating payments of LIBOR + 1 percent. The notional principal is $50 million. LIBOR is expected to 7 percent, 9 percent, and 10 percent, respectively, at the end of each of the next three years.
a. Determine the net dollar amount to be received (or paid) by Cleveland each year.
ANSWER:
End of Year:
END OF YEAR
1
2
3
LIBOR
7
9
10
Floating Rate Received
8
10
11
Fixed Rate Paid
8
8
8
Swap Differential
0
2
3
Net Dollar Amount Received
(Based on a Notional Value of $50 Million)
0
1000000
1500000
b. Determine the dollar amount to be received (or paid) by the counterparty on this interest rate swap each year based on the forecasts of LIBOR assumed above.
ANSWER: Year 1 = $0; Year 2 = $1,000,000 paid; Year 3 = $1,500,000 paid
2. Interest Rate Caps. Northbrook Bank purchases a four-year cap for a fee of 3 percent of notional principal valued at $100 million, with an interest rate ceiling of 9 percent, and LIBOR as the index representing the market interest rate. Assume that LIBOR is expected to be 8 percent, 10 percent, 12 percent, and 13 percent, respectively, at the end of each of the next four years.
a. Determine the initial fee paid, and also determine the expected payments to be received by
Northbrook if LIBOR moves as forecasted.
ANSWER:
End of Year:
0
1
2
3
4
LIBOR
8
10
12
13
Interest Rate Ceiling
9
9
9
9
LIBOR’s Percentage
Points Above the
Ceiling
0
1
3
4
Payments to be
Received (Based on
$100 Million of
Notional Principal
0
1000000
3000000
4000000
Fee Paid
3000000
b. Determine the dollar amount to be received (or paid) by the seller of the interest rate cap based on the forecasts of LIBOR assumed above.
ANSWER:
End of
Year 0 = $3,000,000 received
Year 1 = $0
Year 2 = $1,000,000