On June 12, 2020, the term structure of risk-free interest rate in America indicates that the annualized continuously compounding 1-year risk free rate is 0.90%, the 2-year rate is 1%, and the 3-year rate is 1.1%. Suppose you have a mortgage for which you have to pay annually a mortgage rate that is linked to the LIBOR variable rate. You are concerned that interest rate will rise over the course of the next three years.

a. [5 points] Describe what swap contracts you would use and how to protect yourself against interest rate uncertainty. You may draw a diagram to indicate the cash inflow and outflow under your original mortgage and the swap contract.

b. [10 points] You goal is to calculate the fair swap rate under this 3-year swap. (1) Clearly identify what inputs would you need to arrive at your conclusion (2) Clearly identify what pricing principle/steps would you use with all the inputs from (1) to arrive at your conclusion. (no numerical results, but please use accurate terminology)

c. [5 points] After entering the swap contract, what risks will you be exposed to? What risks will the swap dealer be exposed to?

d. [5 points] Describe how the dealer can hedge her/his position in the what swap contract

Answer rating: 100% (QA)

a You would use a 3year swap contract to protect yourself against interest rate uncertainty The swap ... View the full answer