Exam 8: Interest Risk and Swaps

The London Interbank Offered Rate (LIBOR)is published under the auspices of the British Bankers Association.A panel of 16 major multinational banks self-report their actual borrowing rate.

The interest rate swap strategy of a firm with fixed rate debt and that expects rates to go up is to:

A firm entering into a currency or interest rate swap agreement holds no responsibility for the timely servicing of its own debt obligations since that responsibility now is born by the second party to the contract.

A firm with variable-rate debt that expects interest rates to rise may engage in a swap agreement to:

For a corporate borrower,it is especially important to distinguish between credit risk and repricing risk.Explain both types of risks.

Instruction 8.1: For the following problem(s),consider these debt strategies being considered by a corporate borrower.Each is intended to provide $1,000,000 in financing for a three-year period∙ - Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%. - Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%,to be reset annually.The current LIBOR rate is 3.50% - Strategy #3: Borrow $1,000,000 for one year at a fixed rate,and then renew the credit annually.The current one-year rate is 5%. -Refer to Instruction 8.1.The risk of strategy #1 is that interest rates might go down or that your credit rating might improve.The risk of strategy #3 is: (Assume your firm is borrowing money. )

Unlike the situation with exchange rate risk,there is no uncertainty on the part of management for shareholder preferences regarding interest rate risk.Shareholders prefer that managers hedge interest rate risk rather than having shareholders diversify away such risk through portfolio diversification.

Instruction 8.1: For the following problem(s),consider these debt strategies being considered by a corporate borrower.Each is intended to provide $1,000,000 in financing for a three-year period∙ - Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%. - Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%,to be reset annually.The current LIBOR rate is 3.50% - Strategy #3: Borrow $1,000,000 for one year at a fixed rate,and then renew the credit annually.The current one-year rate is 5%. -Refer to Instruction 8.1.Choosing strategy #1 will:

A basis point is one-tenth of one percent.