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In this qs itsays that the bank will pay Sembilian a floating rate based on the current yield curve rate?
Then why have the current annual forward rates been taken for yr2-4 in the answer?wont the bank pay based on the current annual spot yield curve rate?Part bii)asks to demonstrate the Sembilians interest payment liability dz not change after the swap,whether the interest rates inc or decrease
How can i demonstrate this?i didnt understand the numbers in the answer at allThanks alot Sir
When it says that the bak will pay based on the current yield curve rate, it means based on whatever the current rate is at the time they make the payment. So the interest each year will go up or down depending on the current yield rate is at the time.
In part (a) you are asked what the interest is that they expect to pay/receive, and so to decide what they are expecting all they can do is use the current forward rates as an expectation of what will happen in the future years.
Part (b) is simply looking at what the net result will be as a result of the swap.
What is happening is that Sembilan continues to pay floating rate on its borrowing, but receives floating rate from Ratus (which ‘cancels’ out the risk because as the interest they pay goes up and down, so too the interest they receive from Ratus goes up and down). In exchange for receiving the floating interest from Ratus, they are paying fixed interest to Ratus of 3.7625%.
So the net effect of it all is that the net payment by Sembilan each year is fixed.
It is the first column that matters (the other two columns – 3% and 4% – are just to illustrate the first column and are not so important.
(The + 60bp and the fee of 20bp are both from the question and should not be a problem)The important bit is to realise that Sembilan will still be paying floating interest to the lender. The swap with Ratus is the Sembilan will receive floating interest from Ratus, and in return pay fixed interest to Ratus.
Sir If the forward 1 yr rate had been given to us,we would have used that to compute the interest receipt right?
Is it acceptable in the exam to just explain the concept and not demonstrate how,if such a qs is asked?
Part a)asks why the fixed annual rate of interest of 3.7625% is less than the 4 yr yield curve rate.So whats the reason?
The forward rates are only ‘guesses’ for the future.
Part (a) asks you to use theses ‘guesses’ to decide on a rate.
Part (b) is using the swap to remove the risk of the actual changes in the spot interest rates.
In the exam, proving that you understand the idea is more important and gets more marks than simply doing the calculations. Provided you can explain the idea, you do not need to illustrate with figures.
The fixed rate is lower because it has in a sense ‘averaged out’ the rates for each of the 4 years. The 3.8% is just the rate for 4 years away.
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