Week 9 - question answered for week 9 tutorial. PDF

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EFB201 Tutorial 9 Questions 11.10 Which do you think has more default risk, a futures contract or a swap contract? Why? 11.15 A bank has entered into an interest rate swap. The swap has a notional principal amount of $100 million and calls for the bank to make annual fixed-rate payments of 8 percent and to receive an annual floating-rate payment of BBSW plus 2 percent. If BBSW is 5 percent, what payment will the bank make or receive? 11.16 Two firms each need $2 million in funds and go to the market for quotes. They are quoted: for A – fixed: 8.3 per cent; floating: BBSW plus 2 per cent; for B – fixed: 9.4 per cent; floating: BBSW plus 2.9 per cent. If A accepts the fixed-rate funds and B the floating-rate funds, then they both decide they can reduce their cost of funds through a swap, can you structure a swap where they both benefit equally? 11.17 Alles Ales (AA) and Barnicle Boats (BB) each need $5 million in funds and go to the market for quotes. They are quoted: for AA – fixed: 7.4 per cent; floating: BBSW plus 2 per cent; for B – fixed: 8.8 per cent; floating: BBSW plus 2.2 per cent. If AA accepts the fixed-rate funds and BB the floating-rate funds, then they both decide they can reduce their cost of funds through a swap, structure a swap where they both benefit equally. 11.18 Construct a table showing the net payments made by the firms in question 11.17 to both the markets and each other for two years if the average value of BBSW is 5 per cent in year 1 and 6 per cent in year 2.

Additional Questions Q1. Assume a 90Dv180D FRA with an agreed rate for borrowing of 6% pa and a nominal face value of $30m. At settlement, the reference rate is 5.4% pa. Calculate the payment or receipt for the customer. Q2. Assume a 60Dv240D FRA with an agreed rate for investing of 5% pa and a nominal face value of $20m. At settlement, the reference rate is 4.6% pa. Calculate the payment or receipt for the customer. Q3. Bank Bill Futures and Forward Rate Agreements (FRA’s) can both be used to hedge against a short term interest rate rise. Discuss. Q4. Discuss the advantages and disadvantages of using swaps to hedge interest rate risk. Q5. Outline how a firm with floating rate debt that becomes worried about a rise in interest rates could use an intermediated swap to reduce its exposure.

EFB201 Tutorial 9 Solutions 11.10 Which do you think has more default risk, a futures contract or a swap contract? Why? The swap contract has more default risk because the swap market is more or less an unregulated market. In contrast, the default risk in the futures market is very low because all trades are made with the clearing house of the exchange and are guaranteed by it. Swaps ha a higher risk than future. Regulator is involved in the future market. 11.15 A bank has entered into an interest rate swap. The swap has a notional principal amount of $100 million and calls for the bank to make annual fixed-rate payments of 8 percent and to receive an annual floating-rate payment of BBSW plus 2 percent. If BBSW is 5 percent, what payment will the bank make or receive? The amount of annual fixed payments made by the bank is $8 million ($100 million x 8%). It will currently receive $7 million ($100 million x 7% (BBSW + 2%)). Net result = $8m - $7m = $1m payment.

11.16 Two firms each need $2 million in funds and go to the market for quotes. They are quoted: for A – fixed: 8.3 per cent; floating: BBSW plus 2 per cent; for B – fixed: 9.4 per cent; floating: BBSW plus 2.9 per cent. If A accepts the fixed-rate funds and B the floating-rate funds, then they both decide they can reduce their cost of funds through a swap, can you structure a swap where they both benefit equally? (firm a has higher credit rating therefore lower interest rate) = lower than firm b. A advantage in fixed = 8.3% versus 9.4% = 1.1% A advantage in floating = BBSW + 2% versus BBSW + 2.9% = 0.9% Comparative advantage for A in fixed funding = 0.2% If gain is split equally, each party should be 0.1% better off (i.e. A needs BBSW + 1.9% (2 – 0.9) and B needs 9.3% (0.4-0.1)). BBSW is used as the floating side rate, so fixed side must be 8.3% - 1.9% = 6.4%.

Pays to market Pays to other Receives from other Net result

A - 8.3% - BBSW + 6.4% BBSW + 1.9%

B -(BBSW + 2.9%) - 6.4% + BBSW 9.3%

11.17 Alles Ales (AA) and Barnicle Boats (BB) each need $5 million in funds and go to the market for quotes. They are quoted: for AA – fixed: 7.4 per cent; floating: BBSW plus 2 per cent; for B – fixed: 8.8 per cent; floating: BBSW plus 2.2 per cent. If AA accepts the fixed-rate funds and BB the floating-rate funds, then they both decide they can reduce their cost of funds through a swap, structure a swap where they both benefit equally. AA advantage in fixed = 7.4% versus 8.8% = 1.4% AA advantage in floating = BBSW + 2% versus BBSW + 2.2% = 0.2% Comparative advantage for AA in fixed funding = 1.2% If gain is split equally, each party should be 0.6% better off (i.e. AA needs BBSW + 1.4% and BB needs 8.2%). BBSW is used as the floating side rate, so fixed side must be 7.4% - 1.4% = 6%.

Pays to market Pays to other Receives from other Net result

AA - 7.4% - BBSW + 6.0% BBSW + 1.4%

BB -(BBSW + 2.2%) - 6.0% + BBSW 8.2%

11.18 Construct a table showing the net payments made by the firms in question 11.17 to both the markets and each other for two years if the average value of BBSW is 5 per cent in year 1 and 6 per cent in year 2.

AA pays to market 7.4% AA pays to BB BBSW AA receives from BB 6% Net effect Net effect (as %) (BBSW+1.4%)

Year 1 $370 000 (5000000 * 0.74) $250 000 (5000000 * 0.05) $300 000 5000000 * 0.06) $320 000 6.4%

Year 2 $370 000 (5000000 * 0.06) $300 000 (5000000 * 0.06) $300 000 $370 000 7.4%

BB pays to market BBSW+2.2% BB pays to AA 6% BB receives from AA BBSW Net effect Net effect (8.2 %)

Year 1 $360 000 (5000000 * (0.05 + .022) $300 000 $250 000

Year 2 $410 000 (5000000* (0.06 + .022))

$410 000 8.2%

$410 000 8.2%

$300 000 $300 000

Q1. Assume a 90Dv180D FRA with an agreed rate for borrowing of 6% pa and a nominal face value of $30m. At settlement, the reference rate is 5.4% pa. Calculate the payment or receipt for the customer. (180 – 90 = 90 days remaining) As agreed rate is above the reference rate, then customer will be required to pay the bank. Payment can be calculated as the difference in price for two bank bills. Price @ agreed rate = $30m/(1 + .06 x 90/365) = $29 562 635 Price @ reference rate = $30m/ (1 + .054 x 90/365 (no. days in the contract)) = $29 605 797 Therefore customer will pay $29 605 797 - $29 562 635 = $43 162 to bank Customer have to pay. (agreed > reference, customer will make the payment else will receive.) (who makes the settlement) Q2. As s umea60 Dv2 40DFRAwi t hanag r e e dr a t ef ori nv e s t i ngo f5% paa ndanomi nal f a c ev al ueof$20 m. Ats e t t l e me nt , t her e f e r e nc er a t ei s4. 6% pa. Ca l c ul a t et hepa yme ntor r e c e i ptf o rt hec us t ome r .

As agreed rate is above the reference rate, then the customer will be receive from the bank. Receipt can be calculated as the difference in price for two bank bills. 240 – 60 = 180 (remaining days) Price @ agreed rate = $20m/(1 + .05 x 180/365) = $19 518 717 Price @ reference rate = $20m/(1 + .046 x 180/365) = $19 556 365 Therefore customer will receive $19 556 365 - $19 518 717

= $37 648 from the bank Q3. Bank Bill Futures and Forward Rate Agreements (FRA’s) can both be used to hedge against a short term interest rate rise. Discuss. True, both instruments can be used to hedge against a short term interest rate rise. Selling a bank bill future allows you to benefit if interest rates rise. The futures will fall in price allowing the futures to be closed out (bought) at a lower price. This profit can then be offset against the higher borrowing cost in the physical market. A borrowing hedge on an FRA can be used to protect against an interest rate. If interest rates rise, then the reference rate will be above the agreed rate and the bank will be required to pay the customer. This profit can then be offset against the higher borrowing cost in the physical market. Both contracts are net contracts (no actual borrowing undertaken) and can be priced using the bank bill formula. The futures contract has a secondary market, whilst the FRA doesn’t. The clearing house eliminates any counterparty risk with a futures contract, but there is counterparty risk with an FRA. Margin calls will apply to the futures contract, but not with the FRA. Futures are standardised, but the FRA can be tailored to suit the customer’s needs.

Q4. Discuss the advantages and disadvantages of using swaps to hedge interest rate risk. Advantages: Swaps can be tailored to fit the desired time horizon, notional amount, benchmark rates and settlement dates. For a standard swap, ther created that can be much larger than with other types of instruments. Swap agreements are illiquid instruments, and disposals can be both difficult and expensive. Transaction costs may be large because of typical “tailoring” of a given swap. There’s no regulator (third-party) to monitor in swap. Illiquid – there is no secondary market to sell the contract. The tailored contract is also difficult to sell as it is based on company’s specific agreement. Q5. Outline how a firm with floating rate debt that becomes worried about a rise in interest rates could use an intermediated swap to reduce its exposure. If worried about an interest rate rise, the corporation would wish to change its debt from floating to fixed rate debt. To do this it would contact the bank to arrange a vanilla swap. In the swap, the corporation will pay the fixed swap rate whilst the bank will pay the variable reference rate. If interest rates increase, the corporation will have to make a larger interest payment on its loan but will receive the net difference on the swap. If interest rates decrease, the corporation will have a smaller interest payment on its loan but will have to pay the net difference on the swap. The final result will be fixed interest exposure. e.g.

SWAP Cor p or a t e

Fixed at 5%

Ba n k

Floating at BBSW

Variable Rate at BBSW + 2.5%

Variable Rate Loan Net Result = BBSW + 2.5% - BBSW + 5% = 7.5% Regardless of rate rises, corporate will pay 7.5% fixed....