Question

Consider a permanent payment under plain vanilla. interest rate swap which is paid in advance in following settings. The start date is I year and maturity is 2 years. The floating rate is 24 months. Floating rate is 6-month USD Libor. The rate of swap trading is 5%.

Is it possible to construct swap strategy using options based on interest rate?

Answer 1

Information available:

* Interest rate swap which is paid in advance *

Start date: 1 year

Maturity date: 2 years

Floating rate tenure: 24 months

Floating rate: 6 month USD Libor (0.37% as of 3 July 2020)

Rate of swap: 5%

Swap strategy:

Consider a swap strategy between two companies, Company A and Company B with the above information

Interest rate to be paid by Company A= 5%

Interest rate to be paid by Company B: 6-month USD LIBOR + 1% = 0.37% + 1% = 1.37%

Effective interest rate exchanged:

Interest to be paid by Company A - Interest rate to be paid by Company B = 5% - 1.37% = 3.63%

Therefore, the net transaction involves Company A paying net interest of 3.63% to Company B