Exercises on FRAs and SWAPS

Question 1: A forward rate agreement is an over the counter contract that a certain fixed interest rate will apply to a certain fixed principal amount during a specific future period of time. Suppose that the principal amount is L the FRA contract specifies that the holder (a financial institution say) will receive interest at rate the fixed rate RK on the amount L, for the period from time T1 to time T2 RF = the forward LIBOR interest rate for the period from time T1 to time T2

R = the actual LIBOR interest rate observed at time T1 for a deposit maturing at time T2 , and which has a term of T2 T1

The value of a Forward Rate Agreement is given by the formula

FRAvalue = L ( RK RF )(T2 T1 ) .exp ( R2 .T2 )

The 3 month LIBOR rate is 5% and the 6 month LIBOR rate is 5.5% (both with continuous compounding) A FRA will pay us 7% p.a. fixed (convertible quarterly), on a principal of $1m for the period from the end of month 3 to the end of month 6. Write an excel spreadsheet to compute 1. the prices of zero coupon bonds maturing at times T1 =3 months and T2 =6 months 2. the forward interest rate RF for the period from time 3 months to time 6 months, expressed as a continuously compounded annual interest rate. We can compute this from ZT1 1 the formula RF = ln ZT T2 T1 2 3. the forward interest rate for the period from time 3 months to time 6 months, expressed as 1 a an annual interest rate convertible with frequency m = .We can compute this T2 T1

1 ZT1 from the formula RF = 1 T2 T1 ZT2 4. The value of the FRA

Question 2

One year ago, IBM and BHP entered into a fixed for fixed currency swap. IBM will pay to BP interest on a principal of $20m Australian Dollars at an interest rate of 12%. The payments are to be made annually in arrears for 5 years. BHP will pay IBM interest on a principal of $10m US dollars at an interest rate of 9%. The payments are to be made annually in arrears for 5 years. There will be an exchange of principal at both the start and the end of the swap. Assume that, as at the date the swap is entered into, the exchange rate is $1.00 AUD = 0.50 USD the yield to maturity on the US bond is 9% pa effective the yield to maturity on the Australian bond is 12% pa effective Show that the value of the swap is zero at the date the contract is initiated. Use the formula swapvalue = BD S0 BF (i) One year later, the exchange rate has changed to $1.00 AUD = 0.60 USD, the yield to maturity on the US bond has changed to 10% pa effective and the yield to maturity on the Australian bond has changed to 11% pa effective. Compute the value of the swap to IBM using the portfolio of bonds approach. Set out (in a table) the future cashflows to be paid and received by IBM under this swap arrangement in the 2 currencies Assuming the yield curves are flat in both countries, so that the yield to maturity is the same for all maturities, show how to value the swap (as at time 1 year into the life of the swap) as a portfolio of forward contracts on the exchange rate. In doing this you should compute the fixed exchange rate of the AUD for the USD (the price to be paid in USD for each 1 unit of the AUD) for each of the forward contracts underlying the swap compute the forward exchange rate for delivery at time T in the future, expressed as the number of US dollars it takes to buy 1 unit of the Australian dollar compute the number of forward contracts required or each maturity (assuming each forward contract is over 1 unit of the Australian dollar) compute the value of a forward contract to buy 1 unit of the Australian dollar, for each of the 4 maturities hence compute the value of the swap contract. It should give the same valuation as the answer to part (i)

(ii)

(iii)

Question 3: valuing a floating rate bond:

Suppose that IBM issues a floating rate bond with a term of 3 years on 05-March-2003. The bond pays interest at the 6 month libor rate (this is an annual rate convertible half yearly) and has a face value of $100m. Suppose that the future libor rates are as per the following table
Date 05-March-2003 05-Sept-2003 05-March-2004 05-Sept-2004 05-March-2005 05-Sept-2005 05-March-2006 6-month libor rate 4.20% 4.80% 5.30% 5.50% 5.60% 5.90% 6.40%

(i) (ii) (iii)

Date

compute the bond cashflows on the dates shown in this table using the above libor rates as valuation rates, show that the value at any of the dates above prior to maturity is equal to the face value of the bond. create an excel spreadsheet to produce the following output in the cell range A5:F14
6-month libor rate % pa 4.20% 4.80% 5.30% 5.50% 5.60% 5.90% 6.40% cashflow bond value cumulative discount factor pv of cashflow

5-Mar-03 5-Sep-03 5-Mar-04 5-Sep-04 5-Mar-05 5-Sep-05 5-Mar-06

$2,100,000 $2,400,000 $2,650,000 $2,750,000 $2,800,000 $102,950,000

$100,000,000.00 $100,000,000.00 $100,000,000.00 $100,000,000.00 $100,000,000.00 $100,000,000.00

0.979431929 0.956476494 0.931784212 0.906845948 0.882145864 0.856868251

$2,056,807.05 $2,295,543.58 $2,469,228.16 $2,493,826.36 $2,470,008.42 $88,214,586.42 pv of all cashflows $100,000,000.00

The bonds final cashflow at time 5-Mar-06 is in cell C12. The 6 month libor rate for the period from 5Sep-05 to 5-Mar-06 is in cell B11. The bond value as at 5-Sep-05 is the present value at time 5-Sep-05 of the future cashflow ($102,950,000 on 5-Mar-06) valued at 5.90% p.a. discounted for half a year. This is 100m.
The bond value on 5-Mar-05 is the pv of the bond value on 5-Sep-05 plus the pv of the bond coupon payment on 5-Sep-05. This is ($100,000,000.00+$2,800,000)/(1+5.60%/2) = $100m. By working backwards from the maturity date to the valuation date we can compute the bond value as at each of the coupon payment dates and then at the valuation date. We call this backwards recursion. You should program excel to value the bond this way. The value at time 5-Mar-03 of the future bond cashflows can be computed by calculating the discount factors for present valuing $1 on each of the future payment dates (as set out in column E) and multiplying by the amount of the cashflows and summing. Note that 0.979431929 = 1/(1+4.20%/2) and that 0.956476494 = 0.979431929 /(1+4.80%/2). The other cumulative discount factors are computed in a similar way. You should program excel to value the bond this way.

Question 4

Suppose that we have a swap that lasts for 3 years it has payments made half yearly in arrears it has a nominal value of $100m the term structure of interest rates is as per columns 2 and 3 of the following table
payment term to continuous (i) maturity spot yield ( Ti ) yTi 1 2 3 4 5 6 0.50 1.00 1.50 2.00 2.50 3.00 10.00% 11.00% 12.00% 13.00% 14.00% 15.00%
Ti yTi

(i) (ii)

compute the zero coupon bond prices ZTi = e

compute the continuously compounded forward rates ZTi1 1 F(Ti1 ,Ti ) = ln ZT Ti Ti 1 i Compute the forward rates expressed as an annual rate convertible with a 1 frequency of m where m = using the formula Ti Ti 1

(iii)

1 ZTi1 1 F(Ti1 ,Ti ) = Ti Ti 1 ZTi

(iv) compute the swap fixed rate for a fixed for floating interest rate swap 100 1 ZTn R = m S = m ZT1 + ZT2 + ... + ZTn

(v)

1 year later the term structure of interest rates has not changed. Compute the swap rate for a new 2 year swap. compute the value of the old swap contract as at a time 1 year into the 3 year life of that swap contract. assume that T0 = 0 and that ZT0 = 1.00 here
Check whether the following results are correct: payment (i) 1 2 3 4 5 6 term to Mat 0.5 1 1.5 2 2.5 3 continuous spot yield 10.00% 11.00% 12.00% 13.00% 14.00% 15.00% ZCB price Z(T(i)) 0.951229 0.895834 0.83527 0.771052 0.704688 0.637628 fwd rate 10.00% 12.00% 14.00% 16.00% 18.00% 20.00% fwd rate 10.2542% 12.3673% 14.5016% 16.6574% 18.8349% 21.0342% swap fixed rate

(vi)

13.2594% 15.1124%

The 3 year - swap fixed rate when the contract was initiated is 15.1124% One year later a new 2 year swap fixed rate is 13.2594% By combining the old swap to receive fixed / pay floating with the new swap to pay fixed and receive floating we create a fixed cashflow every 6 months for the next 2 years. We can value this as an annuity. Value the swap as at time 1 year by decomposing it into a set of 4 forward rate agreements. Compute the value of each of these FRAs and add them up. The value given should match the result of the previous calculation.