Swap Transactions: An Analysis of Fixed and Floating Rates, Papers of Financial Market

Download Swap Transactions: An Analysis of Fixed and Floating Rates and more Papers Financial Market in PDF only on Docsity! Question and Problem Answers page 1 Chapter 27 - Swaps 27 - 1: The Bank of Champaign buys the swap so it pays the fixed amount in order to receive a flexible amount. Bank of Champaign pays fixed rate 9.05% * $100,000,000 / 2 $4,525,000. receives floating rate 6.50% * $100,000,000 / 2 $3,250,000. net payment $1,275,000. Bank of Urbana pays floating rate 6.50% * $100,000,000 / 2 $3,250,000. receives fixed rate 9.00% * $100,000,000 / 2 $4,500,000. net amount received $1,250,000. Intermediary net amount received $25,000. 2 FINANCIAL MARKETS ... AND THE INSTRUMENTS THAT TRADE IN THEM 27 - 2: A. We have a differential of 140 basis points with which to drive the swap. Bond Rate Commercial Paper Rate Busey Bank 10.00% T-Bill + 0.4% Technology Transfer Inc. 12.00% T-Bill + 1.0% Basis point difference (140) 200 60 B. Busey has an absolute advantage in both markets but its comparative advantage is in the ten year bond market because its absolute advantage is greater there. Busey E. interest on bond issue - 10.0% - 10.0% - $50,000. interest received on swap + 11.0% + 11.0% + $55,000. interest payment on swap - (T-Bill + 0.5%) - 9.5% - $47,500. TOTAL - (T-Bill - 0.5%) - 8.5% - $42,500 Technology Transfer Inc E. interest on commercial paper - (T-Bill + 1.0%) - 10.0% - $50,000. interest received on swap + (T-Bill + 0.5%) + 9.5% + $47,500. interest payment on swap - 11.1% - 11.1% - $55,500. TOTAL - 11.6% - 11.6% - $58,000. Intermediary E. TOTAL 0.1% 0.1% $500. C. Busey is paying (T-Bill - 0.5)% which is 90 basis points better than the (T-Bill + 0.4)% they would have paid in this market. Tech Transfer is paying 11.6% which is 40 basis points better than the 12% they would have paid in this market. The intermediary receives 10 basis points. So the total advantage is 140 basis points. D. The notional principal amount is $1,000,000. This is the amount on which we calculate the payments. E. When the T-Bill rate is 9% the payments are calculated as in the third and fourth columns above. CHAPTER 27 - INTERNATIONAL EQUITIES 5 Profit ' 0 ' $63,000 & i50,000 X X ' $63,000 i50,000 ' $1.2600 i B. Every six months the intermediary receives $63,000 and pays i50,000. The dollar value of these two payments is [$63,000 - (i50,000 * exchange rate )]. If the exchange rate is normally distributed with µ=$0.9000 and σ=$0.15 then we have the following: Exchange Rate dollars received dollar value of euros paid payment µ + 3σ $1.3500 $63,000.00 $67,500.00 ($4,500.00) µ + 2σ $1.2000 $63,000.00 $60,000.00 $3,000.00 µ + σ $1.0500 $63,000.00 $52,500.00 $10,500.00 µ $0.9000 $63,000.00 $45,000.00 $18,000.00 µ - σ $0.7500 $63,000.00 $37,500.00 $25,500.00 µ - 2σ $0.6000 $63,000.00 $30,000.00 $33,000.00 µ - 3σ $0.4500 $63,000.00 $22,500.00 $40,500.00 C. Our breakeven rate of exchange is $1.2600 If the exchange rate on the Euro increases beyond $1.26 the intermediary makes a loss. $1.26 - $0.90 = $0.36 so this is 2.4 standard deviations from the mean. The cumulative Normal at 2.4 standard deviations from the mean is 0.00820 so we assure ourselves that there is a 0.82% probability of getting an exchange rate greater than $1.26 and suffering a loss. D. If the exchange rate is normally distributed with mean $0.90 and standard deviation $0.15 then we expect a 68% probability that the exchange rate will be between $.75 and $1.05; a 95% probability that it will be between $.60 and $1.20; and a 99.7% probability that it will be between $.45 and $1.35. These percentages are properties of the normal distribution (see page 47). A five sigma event is when the exchange rate comes in five standard deviations from the mean. The probability of this happening should be less than 0.25% Five standard deviations below gives us an exchange rate of $0.90 - 5($0.15) = $0.15. At $0.15, Euros are practically worthless and the European Union is on the brink of collapse but the Intermediary takes in $50,500 every six months. Five standard deviations above gives us an exchange rate of $1.65. Nobody predicted this but the intermediary is losing $19,500 on every semi-annual payment. If the Intermediary cannot survive or hedge this eventuality then it fails the stress test. 6 FINANCIAL MARKETS ... AND THE INSTRUMENTS THAT TRADE IN THEM $(19,500)$(20,000) $(10,000) $- $10,000 $20,000 $30,000 $40,000 $50,000 $60,000 $- $0.15 $0.30 $0.45 $0.60 $0.75 $0.90 $1.05 $1.20 $1.35 $1.50 $1.65 $1.80 Exchange Rate Se m i-A nn ua l P ay m en t $- $0.15 $0.30 $0.45 $0.60 $0.75 $0.90 $1.05 $1.20 $1.35 $1.50 $1.65 $1.80 Exchange Rate Pr ob ab ilit y ©2006 ELISABETH OLTHETEN AND KEVIN G. WASPI Not to be transmitted, copied, or distributed without express written permission from the authors.