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Hi,
1) In part (a), while calculating expected futures price on 1 Feb why we are subtracting .22 basis from 95.7 and 96.7 , why not adding? Whats the rule?2) In question it is stated ” current basis on March futures price is 44 basis ”
How these are 44 basis when Strike price is either 95.5 or 96 and LIBOR is 3.8%(96.2) and what they indicate on 1Dec?3) Secondly, despite having watched lecture on interest rate swaps, I don’t really understand the rationale behind these. How exactly these work, I think I need some preliminary explanation before going to look at calculations.How do parties decide whether they should borrow at fixed or float rates?
Why do they pay each others interests?Thanks in advance. You are providing such a valuable service. Will remain indebted to you.
1) Although in fact the futures price would usually be lower, it doesn’t have to be. The examiner should have made it clear (and would have to still give the marks if you has added 0.22 instead of subtracting)
2) The basis has nothing directly to do with the options. The options are the right to buy or sell futures at a fixed price, and the basis is the difference between the futures price and the interest rate.
3) A company might prefer to borrow at floating rate if they think interest rates are going to fall. Also, the might prefer to borrow floating if they think there income will go up and down as interest rates go up and down.
The reason a swap might be worthwhile is that different companies are charged different rates of interest depending on how credit-worthy they are.Suppose I can borrow fixed at 10% or floating at L+2%. You are able to borrow fixed at 8% or floating at L+1%.
I want to borrow fixed and you want to borrow floating.If we ignore any swapping and simply do our own borrowing, then in total we pay 10 + L+1 = L + 11%
If we borrowed the opposite of what we actually wanted then in total we pay L+2 + 8 = L + 10% which is less.
However I don’t want floating I want fixed, so effectively we pay each others interest. As a result between us we can save 1% (and we will share the saving). We need to do some settling up in order to make sure that we do both save – I deal with this in the lecture.
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Hi Moffat
If Keshi borrows at L+0.4 & Receives Libor from swap (bank). Why is Keshi not paying 4.6% to the bank (under the swap)?
Why would they do that? The bank is offering either L + 0.3% or 4.6%. They save by taking L + 0.3% – not by taken 4.6%.
There is more than one way of illustrating it. Here is a different way from the examiners answer:
If K borrows fixed at 5.5% and the other borrows floating at L+0.3%, then the total comes to L + 5.8%
If K borrows floating at L+0.4 and the other borrows fixed at L+4.6% then the total comes to L + 5%
So what they should do is the second option and swap i.e. pay each others interest. Between then they will save 0.8% of which K will get 70% which is 0.56% saving.
Without the swap Keshi pays fixed interest of 5.5%.
With the swap they save 0.56% and so end up paying 5.5 – 0.56 = 4.94%. In addition they have to pay 0.1% to the bank which gives a final total of 4.94 + 0.1 = 5.04%.The free lecture on swaps will help you.
I have been scratching my head about this one. Watched the lectures again and also some on youtube… Still could not understand where I was going wrong as I felt like I had a firm grasp of the subject.
Just realised that I was adding the 30/40 basis points as 3/4% instead of 0.3/0.4% – no wonder I could not understand where the examiner got his 0.8 from… Lets hope the brain works on exam day…
Showing your steps above helped – thank you!
Don’t worry – as long as you prove in the exam that you know basically what is going on then you will get the marks 🙂
(But for that reason, make sure you show your workings neatly enough for the marker to be able to understand them!)
Hi John,
I was following one of your lectures based on another SWAP exercise and I see that you are applying the same logic in this case – which I do understand.
But in the answer section for Keshi they are clearly saying that the company is borrowing at LIBOR+0.4 prior to SWAP and you’re mentioning that without SWAP Keshi is paying 5.5%.
So I need to admit that I am a bit lost.
You are misunderstanding the wording of the answer.
Keshi wants fixed rate borrowing. If they borrow themselves they pay 5.5%.
If they do swap borrowing then they borrow floating at L + 0.4% and then swap (so it is L+0.4% before they swap, but they will only do this if they are going to swap 🙂 ).
Hi John,
Can you please let me know where it says Keshi Co wants fixed interest rate.Thanks
It doesn’t state it directly, but it is implied when the question states that there is increasing uncertainty and that the floating rate could increase or decrease.
Also, the only swap that would result in an interest saving is where they end up paying fixed interest (if the swap was the other way there would be no saving and they would end up paying more).
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In part a) for the increase of 0.5% (to 4.3%) the answers they add the 54,600. Howcome this is a gain, as I have it as a loss because you’re buying the strike at 96 and selling at 95.48 futures? making it a loss of 0.52% not a gain?? likewise with the decrease (3.3%) I have a gain of 0.48% between the buying price of 96 and selling at 96.48, in the question they do not add anything?
They are buying put options at 96.
This gives them the right to sell futures at 96. If the futures price is 95.48 then they will exercise the option – buy futures at 95.48 and sell at 96, thus making a gain.
I do suggest that you watch my free lectures on interest rate risk management.
Hi John
if interest rate increases by 0.5% (real borrowing to 4.7%). should be aour effective interest rate as?
Actual interest cost-4.7%
option gain -0.52 (4.52-4.00)
premium-0.902
which comes as 4.7+0.52+0.902=6.11%?
but in the solution they give 5.08%. How?thanks
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