Question

An investment company holds $10 million of a 5-year $100 million RST bond in its portfolio. The bond pays interest on a fixed rate basis equal to 2.30%. Current 5-year treasury rates are 1.50% and the current 5-year swap spread is 30 basis points.

a. To convert the bond payments to a floating rate, the investor should enter into which type of swap and what will be the investor’s net floating rate exposure quoted as a spread to Libor? Be specific on fixed and floating payments. Please show boxes and arrows.

b. After one year Libor goes from 0.5% to 1.5%. What will be the investor’s interest income for the following quarter?

c. After one year, the investment company goes out of business and 4-year interest rate swaps are then 2.8% (this is the combined treasury rate and swap spread). Assuming that there is no collateral posted, what is the present value profit or loss for the bank?

Answer 1