Question: Answer the following We know that a commodity swap is a combination of a loan and a series of forwards. This question tests you in

Answer the following

We know that a commodity swap is a combination of a loan and a series of forwards. This question tests you in this concept. Suppose that oil forward prices for 1 year and 2 years, are $20 and $21 respectively (This implies that you can purchase oil in 1 year, and 2 years at $21 and $22 per barrel, if you sign a forward contract today). The 1 -year effective annual interest rate is 5.0%, the 2-year interest rate is 5.5%.

a. What is the 2-year swap price?

b. Now suppose a dealer (look for dealer's role as counterparty in the chapter on Swaps) writes such a swap and decides to hedge the risk using long forwards for 1 -year and 2 -year). Calculate the profit (loss) for the dealer assuming zero transactions costs in years 1 and 2.

c. Using payoffs calculated in part b., calculate the implied rate of interest that the dealer faces between years 1 and 2. What risk is the dealer still exposed to despite hedging price risk?

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