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Sir could you please explain me part (b) and (c) of the above question.Thank you so much.
With regard to part (b) and interest rate swap involves receiving Libor (from the other person in the swap) and in return paying the other person the fixed rate quoted (which in this question) is 5.4%.
Because they want first the six monthly rate, all the yearly rates are divided by 2.
So….the company is already having to pay L/2 + 0.6% (120 points = 1.2%; divided by 2 is 0.6%)
If they swap the receive L/2.
So so far the net payment is L/2 + 0.6% – L/2 = 0.6%
But they have to pay the other party 5.4%/2 = 2.7%So the overall net payment is 0.6% + 2.7% = 3.3%.
(I assume you are happy about turning this 6 month rate into an effective yearly rate).
Part (c)
For VaR at 95% we need to know how many standard deviations give a probability of 95 – 50 = 45% (or 0.45). If you look in the tables to see which number of standard deviations give an answer of 0.45 you will find it is between 1.64 and 1.65 – so approximately 1.645.
The little problem here is the we need the six-monthly standard deviation but we are only given the yearly standard deviations. We cannot multiply or divide standard deviations, we can only multiple of divide variance (and the variance is the square of the standard deviation).
So…..the yearly variance is (yearly SD)^2
So the six monthly variance is ((yearly SD)^2) / 2
This is the six monthly SD squared, so the six monthly SD = yearly SD divided by the square root of 2.
Hope that helps 🙂
sir thank you so much its much clear now , still want to ask something
b) you said the company is already having to pay L/2 + 0.6% (120 points = 1.2%; divided by 2 is 0.6%)
If they swap the receive L/2. Is this swap with bank.And is this formula correct
Effective annual interest rate=(1+six-month rate)square -1c)And in this part 95-50=45 from where did you get the figure 50
and is ^ the sign of standard deviation.Sorry for asking so much actually I am not able to get any help from anywhere as I am doing self study .And is there any lecture on this standard deviation.
The swap can be with any other party, but it will usually be with a bank.
You are correct with your formula for the effective annual interest rate,
50 is because it all relates to a normal distribution and because it is symmetrical, 50% lie either side of it.
There is not lecture on VaR unfortunately, but you will find a page about it in the free revision notes which might help explain.
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Hi John,
quick question about part b, why is 5.40 rate used instead of 5.25 as the fixed rate being paid(question says “10-year swap rates are quoted at 5.25-5.40”)?
Can either be used or it has the be the higher of the two?
Thanks in advance
The lower rate is relevant if they are depositing, the higher rate if they are borrowing 🙂
Dear John, I am looking at Katmai question c; my BPP suggested answer says, after the calculation of the 6 month volatility pf 1,061 that “this means that at the 95% confidence level, the interest rate will be 2,1% above or below current LIBOR.” may I ask you to clarify where this 2,1% is coming from, would be very helpful ?
You are not going to like this, but I have no idea!
This question was set by the previous examiner and is one of the reasons that he is no longer the examiner.
I can’t believe the current examiner would ask anything like this, and I gave up spending more time on it.
Hello Sir, In the same question part c the model answer calculated at 95% confidence level the interest rate will be 2.1% above or below the current LIBOR. How is this 2.1% was calculated?
and also no current LIBOR rates are given in question do we just put any figure in for current LIBOR rates ?
thanks
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