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Dear John
Bpp kit ques.Katmai co.Dec/09
I have got no clue how BPP answers are estimating six monthly interest rate and effective annual rate using vanilla interest rate swaps .
I just got a hang on how to do swap watching your lectures and reading books but i could not figure this out how they are estimating this rates. I even read technical article DETERMINING INTEREST RATE FORWARDS AND THEIR APPLICATION TO SWAP VALUATION but still no luck.
Please help me.Firstly, this question was set by the previous examiner who asked very strange questions! Vanilla interest rate swaps were only ever mentioned in this question and are not likely to be mentioned again.
However it simply means that they are swapping their current cost of borrowing (of LIBOR + 1.20%) for a receipt of LIBOR and a payment of 5.40%This means they end up paying a net 5.4 + 1.2 = 6.6%
However, because the question says that interest is payable at six-monthly intervals, this mean 6.6% / 2 = 3.3% every six months.
To go from 3.3%% every six months to an annual % is back to Paper F2 (and F9). The yearly equivalent is (1.033^2) – 1 = 0.0671 (or 6.71% per year).
Makes more sense now.By the way did you use swap rate 5.40 instead of 5.25 because its a borrowing?
Thanks a lot again.Yes – borrowing will be at the higher rate, and depositing will earn the lower rate.
John could you help me regarding the requirements of VAR in part c of katmai co.
I do understand the logic behind VAR when doing returns of a project like we did in TISA co.june 2012.
But i did not understood the explanation for this loan that VAR figure of 2.62m dollar means that there is a 5% chance that interest payments would exceed interest expected by 2.62m dollar.
Please explain kindly.Oh dear – this is a dreadful question (it was set by the previous examiner – one of the reasons he is not longer the examiner is because of questions like this!).
Usually, the VaR is calculated in $’s from the very beginning.
Here it is initially calculated as a %, so at the 95% confidence level there is a 5% chance of it being 2.1% above LIBOR. This is then applied to the loan amount to get the actual extra interest.
You are not going to like this, but I must be honest and tell you that I have no idea!!
As I wrote, it is a dreadful question and I gave up on understanding the examiners answer. The current examiner does not ask questions like this.
Its ok. No worries. You are a great teacher and i have got absolutely no doubt about that.God bless.
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