Question

You are a pension fund manager who anticipates having to pay out 8 percent (paid semi-annually) on $100 million for the next seven years. You currently hold $100 million of a floating-rate note that pays LIBOR+0.025. You view this as an attractive investment.

a. You realize that you are facing a risk of not having enough cash to make your fixed payments. On what level of LIBOR, you will not have enough cash to make that fixed payment.

b. You arrange a swap with a dealer who agrees to pay you 6 percent fixed, while you pay it LIBOR. Assume each period is 180 days and there are 360 days in the year. Determine your final cash flow as a percent of the notional amount at each payment date after entering such arrangement.

Answer 1

Answer to part (a)
Pension fund manager have to pay 8%
Pension fund manager Received LIBOR+0.025
If we take both to equal;
LIBOR rate should be 7.975% to make its fixed payment.
Answer to part (b)
Pension fund received = LIBOR + 0.0125 + 3%
Pension fund Paid = LIBOR + 4%
Net Paid = 0.9875%
Final Cash outflow of the notional amount at easch payment date;
= $ 100 million * 0.9875% = $ 0.9875 Million