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  #1  
Old 11-12-2017, 06:26 PM
Futon Futon is offline
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Default interest rate swap question

A reinsurance company enters into a three-year interest rate swap, making annual payments on a notional amount of 2,000,000. The company pays LIBOR plus 0.50% and receives fixed payments under the swap.

The three-year annual effective treasury yield is 2.00% and the swap spread is 0.20%.

The current one-year annual effective LIBOR spot rate is 1.00%.

Calculate the net interest rate swap payment to be received by the reinsurance company in the first year of the swap.
(A) 14,000
(B) 20,000
(C) 24,000
(D) 40,000
(E) 44,000

Quote:
Solution: A
The reinsurance company pays Libor + 0.50%, which is 1% + 0.50% or 1.50% and receives the swap rate which is the treasury rate plus the swap spread or 2% + 0.20% = 2.20%.
The net payment to be received is therefore:
(2.20% 1.50%) 2,000,000 = 0.7% 2,000,000 = 14,000.
I have little clue as to what a the question is asking, even after I've read the SOA document about it. So here are my questions:
  1. Why would anyone want to enter into an interest rate swap?
  2. (2.20% 2,000,000) is what LIBOR charges the company?
  3. How would the solution be different if it's asking for net interest swap pmt received in the second year?

Last edited by Futon; 11-12-2017 at 06:30 PM..
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Old 11-12-2017, 07:39 PM
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Breadmaker Breadmaker is offline
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1. Reducing risk exposure to interest rate changes: Let's say the reinsurer has floating rate assets and fixed rate liabilities. If rates drop, that's bad for the reinsurer. With the swap, they turn their floating rate assets into fixed rate assets.
2. LIBOR is not a company, but a reference rate quoted in the market.
3. For the second year, the net payment will be (2.20 - (LIBOR + 1.0%)) * 2,000,000. It depends on what the LIBOR rate is 1 year from now.
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Last edited by Breadmaker; 11-12-2017 at 09:58 PM.. Reason: Messed up the decimal on the swap spread
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Old 11-12-2017, 07:50 PM
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Quote:
Originally Posted by Breadmaker View Post
1. Reducing risk exposure to interest rate changes: Let's say the reinsurer has floating rate assets and fixed rate liabilities. If rates drop, that's bad for the reinsurer. With the swap, they turn their floating rate assets into fixed rate assets.
2. LIBOR is not a company, but a reference rate quoted in the market.
3. For the second year, the net payment will be (2.20 - (LIBOR + 10%)) * 2,000,000. It depends on what the LIBOR rate is 1 year from now.
Thanks, just to clarify,

1. So is LIBOR this fixed rate?
2. Right, so the company pays (2.20% 2,000,000). Where does that money go?
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Old 11-12-2017, 08:48 PM
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1. No, LIBOR is a floating rate.
2. The fixed payment goes to the counterparts. That counterparty sends the floating payment to the reinsurer.
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Old 11-12-2017, 09:01 PM
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Thank you
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