# Swap Question

(2008 Exam question 7c) 1. Entered into a one year interest rate swap 4 mths ago 2. Red River receives LIBOR pays 5.5% fixed 3. Two month LIBOR is 5.35% 4. 8 month LIBOR is 5.45% 5. Next floating payment will be 5.4% What is the PV? Answer according to guide: Floating = ( 1+0.054(180/360))*(.9912) = 1.0180 Fixed = (.055*180/360)(.9912)+ (1+.055(180/360))*(.9649) Could someone be so kind as to explain to me: 1. How the discount factors (.9912 and .9649) were calculated 2. Why there are two discount factors 3. Why there is an extra payment on the fixed side 4. Why the final payments between the floating and fixed have different discounts

ahhh crap. that was a past CFA exam question? that looks like level II stuff to me.

1. 1/(1+0.0535*(60/360))=0.9912 1/(1+0.0545*(240/360))=0.9649
1. How the discount factors (.9912 and .9649) were calculated first one- 0.0535 x 2/12 = 0.008917 + 1, then 1/that gets you to .9912 go back to your L2 notes, just pretty basic discount formula stuff, you can do it. second rate you’re using the 0.0545 x 8/12… etc. 2. Why there are two discount factors back to L2 notes stuff- floating you only need to get to the next coupon payment, fixed you need to jam the whole thing out… somoene better at swaps can explain why… it’s i think the principal getting returned at the end on the fixed side so you do the discount but add the 1 also. i know how to do them. explain them perfectly, not so much. this was really asked? this seems more L2 swaps than L3 swaps. hmm, time to review derivs. or take a practice test soon.

okay, just found that question, you don’t need to figure out the PV’s to answer it. You just need to know who bears the risk, which is easy just by looking at rates. I learned to value swaps last year, I ain’t doing it again.

jut111 Wrote: ------------------------------------------------------- > okay, just found that question, you don’t need to > figure out the PV’s to answer it. You just need > to know who bears the risk, which is easy just by > looking at rates. > > I learned to value swaps last year, I ain’t doing > it again. Can you advise how to know who bears the risk just by looking at rates ? TKVM !

jut111 Wrote: ------------------------------------------------------- > okay, just found that question, you don’t need to > figure out the PV’s to answer it. You just need > to know who bears the risk, which is easy just by > looking at rates. > > I learned to value swaps last year, I ain’t doing > it again. Red River Receives Fixed at 5.50%, but all the future LIBORs are trading below that. That means the swap is in the money for Red River, which means they are exposed to credit risk. If there counterparty goes BK, they don’t have their good trade anymore.

Are most people in agreement that even though the answer key calculates the PVs of the swap that for this type of question it is unnecessary and that jsnrcomcast’s answer above would be sufficient for full credit?

Thanks

I think this question has been interpreted wrongly.

Question says Red Pays fixed, Receives LIBOR

Since LIBOR is < 5.5% -> RED will pay 5.5% fixed

and so RED will pay - others will receive. The Counter Party will bear the credit risk.

Yea, sorry I just read the posts quickly. Your answer is what I had and I assume is good enough for full credit

The PV of the float leg is 1 except for between payment dates. Hence, you only see one payment being discounted back.

For instance, the last floating payment would be 5.4% and discounted back again with the same rate. So in two months the floating leg would have the PV of 1. You only need to discount it back 2 months.

1*(0.9912) + payment in 2 months discounted back.

I would say for this question the calculation is not necessary for full credit, however if you were to answer as jsjrcomcast originally did you would not receive any points (since he originally had it reversed). If however you had the calculation as well and the grader could see that you only misinterpreted the results you would probably get partial credit.

For max points on the test I would calc this out even though you can see the answer without doing so.