Question

Back Bay Insurance Company negotiated a callable swap involving fixed payments in exchange for floating payments. Assume that interest rates decline consistently up until the swap maturity date. Do you think Back Bay might terminate the swap prior to maturity? Draw the cash flow graph for the fixed and floating payment and explain.

Answer 1

Back Bay pays Fixed Rate and receives a Floating Rate. The cash flow diagram is as shown below:

As it is evident that the receipts for Back Bay are decreasing gradually while the payments are always the same i.e 10%, it would be wise to pre-terminate the swap to avoid losses, (only if the Floating Rate has gone below the fixed-rate and is still decreasing over time) expecting the Floating rate to go down further.

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