I don't understand in part A of the question where they get the figures 5.342% and 4.362% for the Swap in the discussion and recommendation part. I understand the other figures but can't work out this last bit.
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9y ago#1The interest rates you mention are nothing to do with the swap. They are the effective rates if they use options.
The options are options to sell futures at a fixed price.
If LIBOR falls by 0.5% to 3.3% and therefore the futures price will be 100 - 3.3 = 96.70 minus the unexpired basis of 0.22 = 96.48.
With a strike price of 95.50, the option would not be exercised.
Therefore the total cost will be the interest of 7/12 x (3.3% + 0.4%) x $18M = 388,500 plus the premium on the options of 42 contracts x $1M x 3/12 x 0.00662 = $69,510
This gives a total of $458,010.
Therefore the effective annual interest rate is (458,010 / 18,000,000) x 12/7 = 4.362%
The same sort of workings if interest rates increase by 0.5%, except of course that they will then exercise the options.
Have you watched my free lectures on interest rate futures and options? If not, then I really do suggest that you do.
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